WORKBOOK. Second Edition ISBN In this chapter, we have discussed the scope of equity valuation, outlined the valuation process. ISBN (hardback). 1. Investment analysis. 2. Securities— Valuation. 3. Investments—Valuation. I. Pinto, Jerald E. II. Equity asset valuation. ISBN: October Pages Equity Asset Valuation Workbook, Third Edition was designed as a companion to Equity Asset Valuation, .

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Equity Asset Valuation Workbook 2nd Edition. by Workbook. ISBN ISBN Why is ISBN important? ISBN. This bar- code. Equity Asset Valuation Workbook (Cfa Institute Investment) · Read more Business Valuation Body of Knowledge Workbook, 2nd Edition · Read more. Your complete guide to equity assets valuation Equity Asset Valuation Workbook, Third Edition was designed as a companion to Equity Asset Valuation, Third.

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Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www. Discuss the uses of valuation models. Discuss the importance of expectations in the use of valuation models.

Explain the role of valuation in portfolio management. Discuss the steps in the valuation process, and the objectives and tasks within each step.

Discuss the elements of a competitive analysis for a company. Contrast top-down and bottom-up approaches to economic forecasting. Contrast quantitative and qualitative factors in valuation. Discuss the importance of quality of earnings analysis in financial forecasting and identify the sources of information for such analysis. Describe quality of earnings indicators and risk factors. Define intrinsic value.

Define and calculate alpha. Explain the relationship between alpha and perceived mispricing. Discuss the use of valuation models within the context of traditional and modern concepts of market efficiency. Contrast the going-concern concept of value to the concept of liquidation value. Define fair value. Contrast absolute and relative valuation models, and describe examples of each type of model. Explain the broad criteria for choosing an appropriate approach for valuing a particular company.

Discuss the role of ownership perspective in valuation. Explain the role of analysts in capital markets. Discuss the contents and format of an effective research report. Explain the responsibilities of analysts in performing valuations and communicating valuation results. Valuation is most closely associated with the planning and execution steps.

Understanding the business. Forecasting company performance. Selecting the appropriate valuation model.

Converting forecasts to a valuation. Making the investment decision recommendation. The analyst can then make more accurate forecasts. In top-down forecasting, analysts use macroeconomic forecasts to develop industry forecasts and then make individual company and asset forecasts consistent with the industry forecasts.

In bottom-up forecasting, individual company forecasts are aggregated to industry forecasts, which in turn may be aggregated to macroeconomic forecasts. Quality of earnings analysis concerns the scrutiny of possible earnings management and balance sheet management. Ex ante alpha is expected holding-period return minus required return given risk. Historical alpha is actual holding-period return minus the contemporaneous required return.

Equity Asset Valuation Workbook, 3rd Edition

Present value models of common stock also called discounted cash flow models are the most important type of absolute valuation model. As applied to equity valuation, relative valuation is known as the method of comparables: In fulfilling this role, they help clients achieve their investment objectives and contribute to the efficient functioning of capital markets. Analysts can contribute to the welfare of shareholders through monitoring the actions of management.

State four uses or purposes of valuation models. Which use of valuation models may be the most important to a working equity portfolio manager? Which uses would be particularly relevant to a corporate officer? Explain your answer to Part A. Explain the role of valuation in the planning step of the portfolio management process. Explain the role of valuation in the execution step of the portfolio management process. Explain why valuation models are important to active investors but not to investors trying to replicate a stock market index.

KMG for several years. He has consistently felt that the stock is undervalued and has always recommended a strong download. NUE has been similarly bullish. The tables below summarize the prices, dividends, total returns, and estimates of the contemporaneous required returns for KMG and NUE from to The contemporaneous required return is the average actual return for the year realized by stocks that were of the same risk as KMG or NUE, respectively.

The analyst has the following information and assumptions: Calculate ex post alpha, given the following additional information: The table below gives information on the expected and required rates of return based on the CAPM for three securities an analyst is valuing: Define ex ante alpha.

Calculate the expected alpha of Securities 1, 2, and 3 and rank them from most attractive to least attractive. Based on your answer to Part B, what risks attach to selecting among Securities 1, 2, and 3? The research note did not discuss how the target price was obtained or c01a. Assume the target price represents the expected price of MBFG.

What further specific pieces of information would you need to form an opinion on whether MBFG. MI was fairly valued, overvalued, or undervalued? In investigating the financial disclosures of these acquired companies and in talking to industry contacts, you conclude that XMI has been forcing the companies it acquires to accelerate the payment of expenses before the acquisition deals are closed.

As one example, XMI asks acquired companies to immediately pay all pending accounts payable, whether or not they are due. Subsequent to the acquisition, XMI reinstitutes normal expense payment patterns. After it acquires a company, XMI appears to have a pattern of speeding up revenue recognition as well. For example, one overseas telecommunications subsidiary changed its accounting to recognize up front the expected revenue from sales of network capacity that spanned decades.

Characterize the quality of XMI earnings based on its expensing and revenuerecognition policies with respect to acquisitions. State two risk factors in investing in XMI, in the sense in which that term was used in the discussion of quality of earnings. A discounted dividend approach is most c02a.

The free cash flow approach FCFF or FCFE might be appropriate when the company does not pay dividends, dividends differ substantially from FCFE, free cash flows align with profitability, or the investor takes a control majority ownership perspective. The residual income approach can be useful when the company does not pay dividends as an alternative to an FCF approach , or free cash flow is negative.

The required rate of return is the minimum rate of return that an investor would anticipate receiving in order to invest in an asset. The two major approaches to determining the cost of equity are an equilibrium method CAPM or APT and the bond yield plus risk premium method. The equity risk premium for use in the CAPM approach can be based on historical return data or based explicitly on expectational data. When price does not equal value, there will generally be an additional component to the expected holding-period return reflecting the convergence of price to value.

First, we can assign the entire stream of expected future dividends to one of several stylized growth patterns. Second, we can forecast a finite number of dividends individually up to a terminal point, valuing the remaining dividends by assigning them to a stylized growth pattern, or forecasting share price as of the terminal point of our dividend forecasts.

The first forecasting approach leads to the Gordon growth model and multistage dividend discount models; the second forecasting approach lends itself to spreadsheet modeling. The Gordon growth model may be useful for valuing broad-based equity indexes and the stock of businesses with earnings that we expect to grow at a stable rate comparable to or lower than the nominal growth rate of the economy.

Gordon growth model values are very sensitive to the assumed growth rate and required rate of return. For many companies, growth falls into phases. In the growth phase, a company enjoys an abnormally high growth rate in earnings per share, called supernormal growth.

In the transition phase, earnings growth slows. In the mature phase, the company reaches an equilibrium in which factors such as earnings growth and the return on equity stabilize at levels that can be sustained long term. Analysts often apply multistage DCF models to value the stock of a firm with multistage growth prospects. In one version, the growth rate is constant in each of the three stages. In the second version, the growth rate is constant in Stage 1, declines linearly in Stage 2, and becomes constant and normal in Stage 3.

For simpler models like the one-period model, the Gordon growth model, and the H-model , well-known formulas may be used to calculate these rates of return. For many dividend streams, however, the rate of return must be found by trial and error, producing a discount rate that equates the present value of the forecasted dividend stream to the current market price. Adjustments to the expected return estimates may be needed to reflect the convergence of price to value.

Even though such models may use stylized assumptions about growth, they can provide useful approximations. The usefulness of such values reflects the quality of the inputs. The sustainable growth rate depends on the ROE and the earnings retention rate, b: Potential investments can be screened or selected based on their estimated rates of return, along with other portfolio requirements. Often, the discipline involves three steps: AOL , J.

BA are 2. The risk-free rate of return is 4. Calculate the required rates of return for these three stocks using the CAPM. The estimated factor sensitivities of Terra Energy to the five macroeconomic factors in the Burmeister, Roll, and Ross article are given in the table below. The table also gives the market risk premiums to each of these same factors.

Factor Sensitivity Confidence risk 0. The Treasury bill rate is 4. The expression for the value of a stock given a single-period investment horizon has four variables: V0, D1, P1, and r. Solve for the value of the missing variable for each of the four stocks in the table below. The risk-free rate of return is 5. The dividend is expected to grow at 5 percent annually. The risk-free interest rate is 4. Using the Gordon growth model, what is the value of BP? Assuming the Gordon growth model is valid, what dividend growth rate would result in a model value of BP equal to its market price?

The current market prices of three stocks are given below. The current dividends, dividend growth rates, and required rates of return are also given. The dividend growth rates are perpetual. Find the value of each stock with the Gordon growth model. For five utility stocks, the table below provides the expected dividend for next year, the current market price, the expected dividend growth rate, and the beta. The risk-free rate is currently 5. AEP 2. EXC 1. Calculate the expected rate of return for each stock using the Gordon growth model.

Calculate the required rate of return for each stock using the CAPM. Vicente Garcia is a download-side analyst for a large pension fund. He frequently uses dividend discount models such as the Gordon growth model for the consumer noncyclical stocks that he covers. Garcia assumes that the future dividend growth rate will be exactly half of the historical rate.

Garcia uses a beta of 0. If Garcia continues to assume that the future dividend growth rate will be exactly half of the historical rate, what is the value of the stock with the Gordon growth model? If the required rate of return is 7.

DPT is not paying a dividend. Josephson also asserts that DPT has a market value equal to that of many large blue-chip companies, which it does not deserve. What are the price-toearnings and price-to-sales ratios? Nixon and Josephson have agreed on a scenario for future earnings and dividends for DPT. Their assumptions are that sales grow at 60 percent annually for four years, and then at 7 percent annually thereafter.

In Year 5 and thereafter, earnings will be 10 percent of sales. No dividends will be paid for four years, but in Year 5 and after, dividends will be 40 percent of earnings. Dividends should be discounted at a 12 percent rate.

What is the value of a share of DPT using the discounted dividend approach to valuation? Nixon and Josephson explore another scenario for future earnings and dividends for DPT.

They assume that sales will grow at 7 percent in Year 5 and thereafter. Earnings will be 10 percent of sales, and dividends will be 40 percent of earnings. Dividends will be initiated in Year 5, and dividends should be discounted at 12 percent.

What level of sales is required in Year 4 to achieve a discounted dividend valuation equal to the current stock price? Felipe Rodriguez has estimated the required rate of return for Dole using three methods. The methods and the estimates are as follows: Thereafter, the dividend is expected to increase by 7 percent per year for the foreseeable future.

What is the value of the stock? The dividend is expected to grow at a 50 percent annual rate for Years 2 and 3, at 20 percent annually for Years 4 and 5, and at 5 percent annually for Year 6 and thereafter. If the required rate of return is 12 percent, what is the value per share? The dividend is expected to grow at 15 percent for the following four years, and then at 7 percent annually after Year 5. If downloadd at its current price, what is the expected rate of return on EB Systems?

Assume price equals value. Hansen has a beta of 0. An analyst covering this stock expects the Hanson dividend to grow initially at 14 percent but to decline linearly to 5 percent over a year period.

After that, the analyst expects the dividend to grow at 5 percent. Compute the value of the Hanson dividend stream using the H-model. According to the H-model valuation, is Hanson overpriced or underpriced? If an investor pays the current GBP price for the stock, what will be the rate of return? Adapted from CFA Level II exam Your supervisor has asked you to evaluate the relative attractiveness of the stocks of two very similar chemical companies: Litchfield c02a.

You have compiled the data in Table for this purpose. Use a one-year time horizon and assume the following: Treasury bonds yield 8 percent.

Show your work. Justify your choice using your answers to A, B, and C and the information in Table Using the information presented in Table , A. Identify the three components of the DuPont formula. Calculate the sustainable growth rate for Kelly has calculated actual and sustainable growth for each of the past four years and finds in each year that its calculated sustainable growth rate substantially exceeds its actual growth rate.

Cite one course of action other than ignoring the problem Kelly should encourage MasterToy to take, assuming the calculated sustainable growth rate continues to exceed the actual growth rate. Adapted from CFA Level II exam The management of Telluride, an international diversified conglomerate based in the United States, believes that the recent strong performance of its wholly owned medical supply subsidiary, Sundanci, has gone unnoticed.

In developing an investment recommendation for Sundanci, Carroll has directed four of her analysts to determine a valuation of Sundanci using various valuation disciplines. To assist her analysts, Carroll has gathered the information shown in Tables and Calculate ROE for the year Calculate the sustainable rate of growth.

Identify which components of the sustainable growth model, if any, are directly affected by each proposal. Calculate the current value of a share of Sundanci stock using a two-stage dividend discount model and the data from Tables and John Jones, CFA, head of the research department, gathers the information given in Table to help in his analysis.

He gathers the data given in Table Justify each of your conclusions with one reason. Consider each fundamental factor in isolation, with all else remaining equal. She now must value SmileWhite Corporation.

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Risk-free rate 4. First three years: Years thereafter: Describe one weakness inherent in all DDMs. Explain the strengths and limitations of the FCFE model. Contrast the ownership perspective implicit in the FCFE approach to the ownership perspective implicit in the dividend discount approach. Contrast the recognition of value in the FCFE model with the recognition of value in dividend discount models.

Discuss approaches for calculating the terminal value in a multistage valuation model. In some cases, the needed information may not be transparent.

These earnings components either double-count or ignore parts of the cash flow stream. A common approach is to forecast sales, with profitability, investments, and financing derived from changes in sales.

Net income B. Cash operating expenses C. Depreciation D. Interest expense c03a. LaForge Systems, Inc. FCFF, and B. TSM headquartered in Hsinchu, Taiwan. In , when Johnston is performing his analysis, the company—and indeed, the whole industry—is unprofitable. Furthermore, TSM pays no dividends on its common shares.

What is the value of one ordinary share of Taiwan Semiconductor Manufacturing Co. Pham has collected the following information currency in euro: The before-tax cost of debt is 9 percent and the before-tax cost of equity is 13 percent. Using the FCFF valuation approach, estimate the total value of the firm, the total market value of equity, and the value per share. Using the FCFE valuation approach, estimate the total market value of equity and the value per share.

In an attempt to determine if PHB is fairly priced, an analyst has assembled the following information: FCFF is expected to grow at a constant rate of 4 percent for the foreseeable future. BHP Billiton, headquartered in Melbourne, Australia, provides a variety of industrial metals and minerals. The financial information Dunn has assembled for his valuation is as follows: WACC B.

Value of the firm C. Total market value of equity D. Value per share He uses a single-stage FCFE growth model. Similarly, using the base case values for all other variables, calculate the range of stock prices caused by using the low and high values for beta, the risk-free rate, the equity risk premium, and the growth rate. Rank the sensitivity of the stock price to each of the five variables based on these ranges. An aggressive financial planner who claims to have a superior method for picking undervalued stocks is courting one of your clients.

The planner is urging your client to invest in Alcan, Inc. Alcan is the parent of a group of companies engaged in all aspects of the aluminum business. Provide your client with an alternative valuation of Alcan based on a two-stage FCFE valuation approach.

Use the following assumptions: Net income will grow by 20 percent annually for the next three years. Find the value per share of Alcan. Criticize the valuation approach that the aggressive financial planner used. Earnings per share are expected to grow at a decreasing rate for the following five years, as shown in the following table. In , the growth rate will be c03a. The investment in working capital parallels the increase in net capital expenditures and is predicted to equal 25 percent of net capital expenditures each year.

Bron will use debt financing to fund 40 percent of net capital expenditures and 40 percent of the investment in working capital. Find the value per share using a twostage FCFE valuation approach. Adapted from CFA Level II exam, The management of Telluride, an international diversified conglomerate based in the United States, believes that the recent strong performance of its wholly owned medical supply subsidiary, Sundanci, has gone unnoticed.

In developing an investment recommendation for Sundanci, Carroll has gathered the information shown in Tables and Capital expenditures, depreciation, and working capital are all expected to increase proportionately with FCFE. One of the companies he is researching, Mackinac Inc.

Mackinac has released its June financial statements, shown in Tables , , and Mackinac has announced that it has finalized an agreement to handle North American production of a successful product currently marketed by a foreign company.

Show your calculations. Jones is discussing with a corporate client the possibility of that client acquiring a 70 percent interest in Mackinac. SK Telecom Co. The real country return for South Korea is 6.

Equity Asset Valuation Workbook (Cfa Institute Investment)

The long-term real growth rate for South Korea is estimated at 3. What is the real required rate of return for SK Telecom? FCFE is expected to grow at 10 percent for next year, then at 26 percent annually for the following three years, and then grow at 6 percent in Year 5 and thereafter.

What is the value per share? This method involves using a price multiple to evaluate whether an asset is relatively undervalued, fairly valued, or overvalued in relation to a benchmark value of the multiple.

Discounted cash flow models provide the basis and rationale for this method. Fundamentals also interest analysts who use the method of comparables, because differences between a price multiple and its benchmark value may be explained by differences in fundamentals.

EPS, however, is frequently subject to distortion, often volatile, and sometimes negative. The same principle applies to other multiples calculated on a trailing basis. Inflation, technological change, and accounting distortions, however, can impair book value for this purpose. Sales are also more stable than earnings and never negative.

Some common approximations to cash flow from operations have limitations, however, because they ignore items that may be subject to manipulation. The justified price to cash flow based on fundamentals bears a positive relationship to the first factor and an inverse relationship to the second. However, investors trade off future earnings growth to receive higher current dividends. The rationale behind using relative strength is the thesis of patterns of persistence or reversal in returns.

In general, limitations of such screens include the lack of control over the calculation of important inputs and the absence of qualitative factors. SII , an oil field services company subject to cyclical demand for its services. You believe the — period reasonably captures average profitability. The Value Line Investment Survey. Define normal EPS. Price Multiples 2. Neither business has been profitable to date, and neither is anticipated to have positive EPS over the next year.

On the basis of the above information, answer the following questions. State how the analyst might make a relative valuation in this case. Which stock should the analyst recommend? RUF has 30 million shares outstanding and options outstanding for an additional 3,, shares. You are researching the valuation of the stock of a company in the food processing industry.

You calculate Give two reasons why your conclusion that the stock is undervalued may be in error. What additional information about the stock and the peer group would support your original conclusion?

Suppose an analyst uses an equity index as a comparison asset in valuing a stock. Which price multiple s would cause concern about the impact of potential overvaluation of the equity index on a decision to recommend download of an individual stock?

Tables and provide financial statements and other information for Sundanci. Price Multiples 41 i. The risk beta of Sundanci increases substantially. The market risk premium increases. A change in a fundamental factor is assumed to happen in isolation; interactive effects between factors are ignored. Every other item of the company is unchanged.

The computations supporting his analysis follow.

Growth will increase as indicated above and ROE will be steady. Tom Smithfield is valuing the stock of a food processing business. Compute terminal value based on comparables.

Contrast your answer in Part A to an estimate of terminal value using the Gordon growth model. Avtech is a multinational distributor of semiconductor chips and related products to businesses. Its leading competitor around the world is Target Electronics. Based on the information given, answer the following questions: Peninsular has a client who has inquired about the valuation method best suited for comparison of companies in an industry with the following characteristics: Jones recommends that the client consider the following valuation ratios: Support your answer with one reason that makes that ratio superior to either of the other two ratios in this case.

The return on equity is The Treasury bond rate is 4. Price Multiples A. Assume that the dividend and earnings growth rates are 9 percent. Given that the assumptions and constant growth model are appropriate, state whether GE appears to be fairly valued, overvalued, or undervalued based on fundamentals. He has gathered relevant information on the companies in the following table.

Justify your selection. Define the major alternative cash flow concepts, and state one limitation of each.

Data for two hypothetical companies in the pharmaceutical industry, DriveMed and MAT Technology, are given in the table below. For both companies, expenditures in fixed capital and working capital during the previous year reflected anticipated average expenditures over the foreseeable horizon.

Justify your conclusion. Your value-oriented investment management company recently hired a new analyst, Bob Westard, because of his expertise in the life sciences and biotechnology areas. He bases his recommendation to the Investment Committee on two considerations.

Explain the difference between price multiples and relative strength approaches. Kirstin Kruse, a portfolio manager, has an important client who wants to alter the composition of her equity portfolio, which is currently a diversified portfolio of 60 global common stocks. The client wants a portfolio that meets the following criteria: The table below shows how many stocks satisfied each screen, which was run in November Critique the construction of the screen.

Do these screens identify an appropriate replacement portfolio for the client? Describe alternative measures of residual earnings, such as economic value added. Discuss the uses of residual income models. Calculate future values of residual income given current book value, earnings growth estimates, and an assumed dividend payout ratio. Calculate the intrinsic value of a share of common stock using the residual income model.

Contrast the recognition of value in the residual income model to value recognition in other present value models. Discuss the strengths and weaknesses of the residual income model. Justify the selection of the residual income model for equity valuation, given characteristics of the company being valued.

Identify and discuss the fundamental determinants or drivers of residual income. Explain the relationship between the justified price-to-book ratio and residual income. Explain the relationship of the residual income model to the dividend discount and free cash flow to equity models. Discuss the major accounting issues in applying residual income models.

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

Define continuing residual income and list the common assumptions regarding continuing residual income.Associate Exam free site book C Instruments Real Books free site book These earnings components either double-count or ignore parts of the cash flow stream. This workbook provides key study tools, such as learning outcomes, chapter summaries, practice problems, and detailed solutions, that guide you in your preparation for the third step in the CFA certification program.

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