Cheat Sheet Test 2 - Summary Business Valuation II PDF

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In the context of DDM and relative valuation, a company increasing its reinvestment rate will always have a higher P/E ratio. (All else equal). False if ROE1

=1

Vo Firm =

FCFF 1 WACC − g

, bstable=

FV= MV of Equity + MV of Debt

g ROC

EV (enterprise value) = MV of Equity + MV of debt- Cash

(recovering the rate of return on equity) re= g +

DPY (1+g) PE

FCFF= EBIT(1-t) - (Capital Exp.Dep.)- Non-cash working capital WACC= (

E ) ke + ( E+ D

D ) rd(1-t) E+ D Note: D. E are the market value of debt and equity, rd is before-tax cost of debt

Ke= rf + B(rm-rf) Value of Unlevered Firm=

FCFF 0(1+ g) Ke ,unl− g ßL ßu = 1+(1−T )× D /E Value of tax benefits = Tax rate × Debt PV of Exp. Bankr. Costs=(Prob. Of Bankr.) × (PV Bankr. Cost)

¿ π a BC

APV of the firm →Vlevered=

FCFF 0(1+ g) Ke ,unl− g π a BC

+ Tc×D-

EVA= (ROC-COC) ×Capital invested

ßl= ßu [1+(1-Tc)

D E

]

EV/ REVENUE is better than P/S ratio P/S=

Some firms with large cash holding will have EV/ Revenue values than are lower than their PS ratio: If Net Debt (=Debt - Cash) P/S

Not allow to use ‘negative’ EBITDA in EV/EBITDA. In this case, must be ‘negative’ EV. This means, arbitrage in theory, severely valuation in practice.

The debt level that maximizes the value of the firm is the optimal capital structure for the firm. APV Is separates effects of debts into its tax shields (advantages), disadvantages (probability of bankruptcy). Do not have to assume the debt-equity ratio stays constant forever.

Have to estimate probability of bankruptcy and bankruptcy costs. Assuming the same debt level forever is equally unrealistic as assuming the same debt-equity ratio forever. EBIT: Earnings before interest and taxes APV is more practical when capital structure is (operating income) expected to change over the life of the firm. EBIT(1-t): Earnings before interest but after The debt level that maximizes the value of the firm is the optimal capital structure for the firm. taxes (after-tax operating income) Topic 7 Lower risk aversion (means market risk Price to sales (PS) premium is low) → COE, Market risk  It is almost always possible to compute PS as premium is lower, then P/E↑ opposed to PE and PB ratios  Largely driven by the profit margins of each asset Higher risk appetite (higher risk premia)  Much easier to compare between assets in different →Have lower market risk premium countries with different accounting rules. EV/EBIT and EV/EBITDA are examples of Perceived as risker→ P/E lower uniform ratios. EV: Value of firm; EBIT Earn Higher returns → P/E higher &EBITDA: operating income EV/Net Income is not a uniform ratio as EV is a Topic 6 measure of firm assets while net income is a FCFE is a much more intuitive measure than measure of equity earnings. FCFF. Price to EBITDA is not uniform ratio, as price is Focus on pre-debt cash flows like FCFF can measure of firm, EBITDA is measure of operating sometimes lead to overestimating chances of income. survival for a company with heavy debt burden. PS ratio is inconsistency: Revenue belong to the The use of debt ratios in calculating cost of capital entire firm (debt and equity). Price of a share of requires a strong forecast of future capital stock(equity) structures for the firm. Median values are better estimates when there are Cost of capital an APV Valuation not necessary firms with very large and very low values present yield the same valuation. cuz in the sample. COC in the use of WACC essentially  Cost of equity in turn is largely dependent upon assumes that the debt-equity ratio stays risk-free interest rates, equity betas and the market the same forever. risk premium.  APV essentially assumes that the debt level Relationship: stays the same forever when it calculates  Note the non-linearity of the ratios with the present value of the tax shields from respect to growth rates and the cost of borrowing. equity. APV with constant debt level will yield a more Limitation of Statistical Techniques conservative valuation. However, APV depends Multiple values may not be normally distributed. to a large extent in accurately measuring expected bankruptcy costs. (not easy to do) Multiple values may have a non-linear relationship After-tax operating income used to estimate FCFF with fundamental variables like growth and beta. should be the same that is used to compute EVA. Multiple regression assumes that all the Growth rate for after-tax operating income should independent variables are independent of each be estimated by doing DCF for firm valuation. other. Firm is breaking even on its capital in the very Non-stationary distribution of multiples over time DCF vs Relative valuation method long-term (e.g. ROC=COC). DCF and relative valuation will provide different Staring with an all-equity funded firm, values at the same point in time increasing leverage ratio tend to increase firm Relative valuation method will provide different value initially due to tax shields. estimates based on which ratio we use, because Increasing debt levels to unsustainable levels,  DCF assumes the market makes mistakes tends to decrease firm value as the probability sometimes mispricing whole sectors(market) of bankruptcy increases.  Methods have different takes on market Firm value is maximized when COC is inefficiencies. minimized.

EBITDA: Earnings before interest, taxes, depreciation, and amortization



Relative valuation assumes that while the market makes mistakes on individual stocks, the average stock is fairly valued. Topic 8 Market to Book ratio 

Impossible to compute if book value is negative



May result in extremely high values if book value per share is close to zero

Price to sales ratio 

Almost always possible to compute



Exception is a few firms reporting zero sales that have small market values

PE ratio If equity betas increase, the P/E ratio deceases If the payout ratio, then P/E increases

1.Lizzy Inc is forecast to have an annualized earnings growth rate 9% in each of the next 5yrs. The Co. currently trading at a P/E ratio of 90. Based on this info, the PEG ratio of Lizzy must be equal to:

2.Jane Corp. expected to have an ROE=20%, a net profit margin, NPM, =10% and is currently trading at a P/E ratio= 50. The implied values of Jane Corp.’s P/B and P/S ratios must be=?

3. valuation Frodo Corp. is currently trading at a P/E ratio of 20 and has a dividend yield of 50%. According to the one-stage dividend model in the context of relative, the current dividend payout ratio of Frodo must be=?

PEG ratio Firms with higher payout ratios have higher PEG ratios Firms with higher betas have lower PEG ratios Firms with higher expected growth rates have lower PEG ratios PB ratio High rates of return on equity, growth rate and payout ratios increase P/B ratio Higher value of beta will decrease P/B PS ratio Firms with higher net margin, growth rate have higher PS ratios

4.Fakebook Inc, is currently trading at a P/E ratio of 20 and a P/B ratio of 5. The value of Fakebook Inc.’s ROE implicit in these two ratios must be=? 5.Flostsam Corp. have just completed an initial public offering. Their newly issued shares are currently trading at P/E multiple of 100 and P/S multiple of 10. The value of Flotsam’s net profit margin implicit in these multiples must be equal to? 6.Corp. is currently trading at a P/D ratio of 20, a P/E ratio of 10 and a P/B ratio of 2. Assuming that Corp.’s market price is efficient, what is the implicit cost of equity, re =?

Firms with higher values of beta tend to have lower PS ratios An increase in interest rate typically results in higher cost of equity and lower P/E ratio Lower risk aversion tends to decrease the market risk premium and cost of equity leading to higher P/E ratios An increase in expected growth rates across firms will lead to higher P/E ratios for stocks and the entire market An increase in the return on equity at firms will lead to a higher payout ratio given any growth rate and higher P/E ratio for all firms Countries with higher real interest rates will tend to have lower P/E ratio

7. Corp. is currently trading at a P/S multiple of 5 and an EV/S multiple of 4. The only way this can be possible is if Cash Pile Corp. has

8.Inc currently has a rate of return on capital (ROC)of 10% and is expected to be able to maintain that in perpetuity. Inc. is expected to reinvest 40% of its free cash flow to the frim. The Co. is expected to have a free cash flow to the firm of $1milliom next yr and will have a weightedaverage cost of capital of 9%in perpetuity. The intrinsic value of the firm today must be=?

Countries with higher expected real growth rates should have higher P/E ratios Countries that are having higher risk premium should have lower P/E ratios Countries where companies earn higher returns on their investments should have higher P/E ratios

9. Corp. currently has pays no dividend and is trading at a current P/E ratio of 20 and a P/B ratio of 10. Based on these multiples, the PEG ratio of Corp. must be =?

Topic 9 Value/ Book Capital Always possible to compute as the book value of capital is always positive (even when the book value of equity is negative.) EV/ Revenues →Consistent ratio. Measure of firm value

10. Inc. currently pay no dividends and are trading at a current P/E ratio of 8 and a P/B ratio of 5. What is the implicit expected value of Inc.’s future earnings growth rate=?

PS↑

PEG↑ PS↑

A high value for the forward EV/EBIT (1-t) ratio can be caused by a high expected growth rate. A low value for the forward EV/EBIT (1-t) ratio can be caused by a high cost of capital. A high value for the current EV/Sales ratio can be caused by a high value of the after-tax operating margin, ATOM. A high value for the current EV/Book Value of capital is consistent with a high value of the capital reinvestment rate. A low value for the current EV/Sales ratio can be caused by a high cost of capital. A large value for the current EV/Sales ratio can be caused by a high expected growth rate. A high value for the current PEG ratio is consistent with a high value of the dividend payout ratio. A low value for the forward PD ratio can be caused by a high leverage ratio. A sudden increase of the current dividend yield (i.e. dividend per share divided by the current stock price) can be caused by a sharp decrease in the current stock price.

EV< 0 Technically an arbitrage, practically a mispricing/ poor governance indicator PE→ g, payout, risk PB→ g, payout, risk, ROE PS→ g, payout, risk, net margin Growth ↑

Cost of Capital ↑

EV/EBITDA ↑

EV/EBITDA ↓

EV/EBIT ↑

EV/EBIT ↓

EV/EBIT (1-t) ↑

EV/EBIT (1-t) ↓

EV/Capital ↑

EV/Capital ↓

EV/ Sales ↑

EV/ Sales ↓

ROC ↑

After-tax operating margin ↑

EV/EBITDA ↑ EV/EBIT ↑ EV/EBIT (1-t) ↑ EV/Capital ↑ EV/ Sales ↑

EV/EBITDA ↑ EV/EBIT ↑ EV/EBIT (1-t) ↑ EV/Capital ↑ EV/ Sales ↑

Tax rate ↑ EV/EBITDA ↓ EV/EBIT ↓ EV/EBIT (1-t) ↓

Beta ↑ COE↑ PE↓ PEG↓ PBV↓ PS↓

EV/Capital ↓ EV/ Sales ↓ Growth ↑ PE↑ PBV↑ PS↑ PEG↓

ROE ↑ Retention ration↓ PE↑ PBV↑ PEG↑ PS↑

Net Margin ↑ PE↑ PBV↑ PEG↑

Net Margin ↑ PE↑ PBV↑

I/R ↑ COE ↑ P/E↓...