CFA level 2 study notebook3 2015

calculate and interpretanequity risk premium using historical and lookingestimationapproaches, page23 forward-c.. estimateacompany’svalue using the appropriate free cash flow models.. B

BOOK 3 - EQUITY

StudySession 10 - EquityValuation: Valuation Concepts 9

StudySession11- EquityValuation: Industry and Company Analysis

SCHWESERNOTES™ 2015 CFALEVELIIBOOK3:EQUITY

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ISBN:978-1-4754-2771-4/1-4754-2771-9

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success.

READINGS AND

READINGS

Thefollowing materialisa reviewofthe Equity principles designedtoaddress the learning

outcome statements setforthbyCFA Institute

STUDY SESSION IO

Reading Assignments

Equity, CFAProgramCurriculum,Volume4,Level II(CFAInstitute,2014)

28.Equity Valuation:Applications andProcesses

29 Return Concepts

page9page 21

STUDY SESSION II

Reading Assignments

Equity,CFAProgramCurriculum,Volume4,Level II(CFAInstitute,2014)

30.TheFiveCompetitiveForcesThat Shape Strategy

31.Your Strategy NeedsaStrategy

32 Industry and Company Analysis

33 Discounted Dividend Valuation

page43

page61page 70page 95

STUDY SESSION12

Reading Assignments

Equity, CFA ProgramCurriculum,Volume4,LevelII (CFAInstitute,2014)

34.FreeCashFlow Valuation

35 Market-Based Valuation:Priceand Enterprise Value Multiples

36.ResidualIncomeValuation

37.PrivateCompany Valuation

page140page 186page232page 264

LEARNINGOUTCOME STATEMENTS(LOS)

STUDY SESSIONIO

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

28 Equity Valuation:Applications andProcessesThe candidate should be ableto:

a. define valuation andintrinsic value,and explainsourcesof perceived mispricing

(page9)

b explain the goingconcernassumption, andcontrast agoingconcernvalueto a

liquidationvalue,(page10)

c. describe definitionsofvalue,and justify which definition of valueismostrelevanttopublic companyvaluation,(page10)

d describe applications of equityvaluation,(page10)

e. describe questions that should be addressedinconductinganindustry andcompetitive analysis, (page12)

f contrastabsolute and relative valuationmodels,and describe examples of each

typeofmodel,(page13)

g describe sum-of-the-parts valuation and conglomeratediscounts,(page14)

h explainbroadcriteriafor choosingan appropriateapproach for valuingagivencompany, (page15)

Thetopicalcoveragecorresponds with thefollowingCFAInstituteassignedreading:

29 ReturnConceptsThe candidate should be ableto:

a. distinguishamongrealized holding periodreturn,expected holding period

return,requiredreturn, returnfrom convergence of pricetointrinsic value,discountrate,and internalrateofreturn,(page21)

b calculate and interpretanequity risk premium using historical and lookingestimationapproaches, (page23)

forward-c. estimatethe requiredreturn on anequityinvestmentusing thecapitalasset

pricingmodel,the Fama-Frenchmodel,the Pastor-Stambaughmodel,macroeconomicmultifactormodels,and the build-up method (e.g., bond yieldplus risk premium), (page27)

d explain betaestimationfor public companies, thinly traded public companies,andnonpublic companies, (page32)

e. describe strengths and weaknesses of methods usedtoestimatethe required

return on anequityinvestment,(page34)

f explain international considerationsinrequiredreturn estimation,(page34)

g explain and calculate the weighted averagecostof capital foracompany

(page35)

h evaluate the appropriateness of usingaparticularrateofreturn as adiscount

rate,givenadescription of the cash flowtobe discounted and other relevantfacts,(page35)

STUDY SESSION II

The topical coveragecorrespondswith thefollowingCFAInstituteassigned reading:

30 TheFiveCompetitiveForcesThat Shape Strategy

The candidate should be ableto:

a. distinguishamongthe five competitive forces and explain how they drive

industryprofitabilityinthemedium and longrun.(page43)

b describe why industry growthrate,technology andinnovation, government,

and complementary products andservices arefleeting factors rather than forcesshaping industrystructure,(page46)

c. identify changesinindustrystructure,andforecast their effectsonthe industry’s

profit potential, (page47)

d explain how positioningacompany,exploiting industrychange,andshaping

industrystructuremaybe usedtoachieveacompetitive advantage, (page48)The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

31 Your Strategy NeedsaStrategy

The candidate should be ableto:

a. describepredictability and malleabilityasfactorsinassessinganindustry

(page61)

b describe howanindustry’s predictability and malleabilityareexpectedtoaffect

the choiceofanappropriatecorporate strategy(classical,adaptive,visionary,or

shaping), (page62)

c. evaluate the predictability and malleability ofanindustry and selectan

appropriatestrategy,(page63)

The topicalcoveragecorresponds with thefollowingCFA Instituteassigned reading:

32 Industry and Company Analysis

The candidate should be ableto:

a. comparetop-down, bottom-up, and hybrid approaches for developing inputsto

equity valuationmodels, (page70)

b compare “growth relativetoGDPgrowth” and “market growth and market

share” approachestoforecastingrevenue

c. evaluate whethereconomiesof scalearepresentinanindustry by analyzing

operating margins and saleslevels, (page71)

d forecast the followingcosts: costof goodssold,selling general and administrative

costs,financingcosts,andincometaxes, (page71)

e. describe approachestobalance sheet modeling, (page74)

f describe the relationship betweenreturn oninvested capital and competitive

advantage, (page75)

g explain how competitive factors affect prices andcosts, (page75)

h judge the competitive position ofacompany basedonaPorter’s five forces

analysis, (page75)

i explain howtoforecast industry and company sales andcostswhen theyare

subjecttoprice inflationor deflation, (page76)

j evaluate theeffects of technological developmentson demand,selling prices,

costs,and margins, (page78)

k explain considerationsinthe choiceofanexplicit forecasthorizon, (page79)

1 explainananalyst’s choicesindeveloping projections beyond the short-term

forecasthorizon, (page79)

m. demonstrate the development ofasales-basedproformacompanymodel

(page80)

(page70)

Thetopical coverage corresponds with thefollowingCFA Instituteassigned reading:

33 Discounted Dividend ValuationThe candidate should be ableto:

a. compare dividends,free cashflow,and residualincomeasinputstodiscountedcash flowmodels,andidentifyinvestment situationsfor which eachmeasureissuitable,(page95)

b calculate and interpret the value ofa commonstock using the dividend discountmodel(DDM)for single and multiple holding periods, (page98)

c. calculate the value ofa commonstock using the Gordon growthmodel,and

explainthe model’sunderlyingassumptions,(page101)

d calculate and interpret the implied growthrateof dividends using the Gordongrowth model andcurrentstockprice,(page102)

e. calculate and interpret thepresentvalue of growth opportunities(PVGO)andthecomponentof the leading price-to-earningsratio (P/E)relatedtoPVGO

(page103)

f calculate andinterpretthe justified leading and trailingP/Esusing the Gordongrowthmodel,(page104)

g calculate the valueof noncallable fixed-rate perpetual preferredstock,(page106)

h describe strengths and limitations of the Gordon growthmodel,and justifyitsselectiontovalueacompany’scommonshares,(page107)

i explain the assumptions and justify the selection of thetwo-stage DDM,theH-model,the three-stageDDM, orspreadsheet modelingtovalueacompany’s

common shares,(page108)

j explain the growth phase, transitional phase, and maturity phase ofabusiness

(page111)

k describe terminalvalue,and explain alternative approachestodetermining theterminal valueinaDDM.(page112)

1 calculate and interpret the value ofcommonshares using thetwo-stage DDM,

theH-model,and the three-stageDDM.(page113)

m estimatearequiredreturnbasedonanyDDM,including the Gordon growthmodel and the H-model (page118)

n explain theuseof spreadsheet modelingtoforecast dividends andtovalue

common shares,(page121)

o. calculate and interpret the sustainable growthrateofacompany,demonstrate theuseofDuPontanalysistoestimateacompany’s sustainablegrowthrate, (page122)

p evaluate whetherastockis overvalued,fairlyvalued,orundervalued by themarket basedonaDDM estimateofvalue,(page124)

and

STUDY SESSION12

The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

34 FreeCash Flow ValuationThe candidate should be ableto:

a. comparethefree cash flowtothe firm(FCFF)and free cash flowtoequity(FCFE)approachesto valuation,(page142)

b explain the ownership perspective implicitinthe FCFE approach, (page143)

c. explain the appropriate adjustmentsto net income,earnings beforeinterestand

taxes(EBIT),earnings beforeinterest, taxes,depreciation, andamortization(EBITDA),and cash flowfrom operations(CFO)tocalculate FCFF and FCFE

(page143)

d calculate FCFF and FCFE (page150)

e. describe approaches for forecasting FCFF and FCFE (page154)

f compare the FCFE model and dividend discountmodels,(page155)

g explain howdividends,share repurchases, shareissues,and changesinleverage

mayaffect future FCFF and FCFE (page155)

h evaluate theuseofnetincomeand EBITDAasproxies for cash flowin

valuation,(page155)

i. explain the single-stage (stable-growth),two-stage,and three-stage FCFF and

FCFEmodels,and select and justify the appropriate model givenacompany’scharacteristics,(page156)

j estimateacompany’svalue using the appropriate free cash flow model(s)

(page159)

k explain theuseof sensitivity analysisinFCFFand FCFEvaluations, (page166)

1 describe approaches for calculating the terminal valueinamultistage valuation

model,(page167)

m evaluatewhetherastockis overvalued,fairlyvalued, orundervalued basedona

free cash flow valuationmodel,(page167)Thetopicalcoveragecorresponds with thefollowingCFAInstituteassignedreading:

35 Market-Based Valuation:Priceand Enterprise ValueMultiples

The candidate should be ableto:

a. distinguish between the method of comparables and the method basedon

forecasted fundamentalsasapproachestousing pricemultiplesin valuation,andexplaineconomicrationalesfor each approach, (page186)

b calculate and interpretajustified pricemultiple, (page188)

c. describe rationalesfor and possible drawbackstousing alternative price

multiples and dividend yieldinvaluation, (page188)

d calculate and interpret alternative price multiples and dividend yield, (page188)

e. calculate and interpret underlying earnings, explain methods of normalizing

earningsper share(EPS),and calculate normalized EPS (page194)

f explain and justify theuseof earnings yield(E/P),(page196)

g describe fundamentalfactors that influence alternativepricemultiples and

dividend yield, (page197)

h calculate and interpret the justified price-to-earningsratio (P/E),

price-to-bookratio (P/B),and price-to-salesratio (P/S)forastock,basedonforecastedfundamentals,(page197)

i calculate and interpretapredictedP/E,givenacross-sectional regression

onfundamentals,and explain limitationstothe cross-sectional regressionmethodology, (page201)

j evaluateastock by the method of comparables, and explain theimportanceof

fundamentalsinusing the method of comparables, (page203)

k calculate and interpret the P/E-to-growthratio (PEG),andexplainits use in

relativevaluation,(page205)

1 calculate and explain theuseof price multiplesindetermining terminal valuein

amultistagediscounted cash flow(DCF)model,(page206)

m. explain alternative definitions of cash flow usedinprice and enterprise value

(EV)multiples, and describe limitations of eachdefinition,(page207)

n. calculate and interpretEVmultiples, and evaluate theuseofEV/EBITDA

(page209)

o. explainsourcesof differencesincross-border valuation comparisons, (page211)

p describemomentumindicators and theiruseinvaluation,(page212)

q explain theuseof the arithmeticmean,the harmonicmean,the weighted

harmonicmean,and themediantodescribe the central tendency ofagroup ofmultiples, (page213)

r. Evaluate whetherastockis overvalued,fairlyvalued,orundervalued basedon

comparisons ofmultiples, (page203)

The topical coverage corresponds with thefollowingCFA Instituteassigned reading:

36 ResidualIncomeValuationThe candidate should be ableto:

a. calculate and interpret residualincome,economicvalueadded,and market valueadded,(page232)

b describe theusesof residualincomemodels,(page235)

c. calculate theintrinsicvalueofacommonstock using the residualincome model,andcomparevalue recognitioninresidualincomeandotherpresentvaluemodels,(page235)

d explain fundamental determinants of residualincome,(page238)

e. explain the relation between residualincomevaluation and the justified price-

to-bookratiobasedonforecastedfundamentals,(page239)

f calculate and interpret theintrinsicvalue ofa commonstock usingsingle-stage

(constant-growth) and multistage residualincomemodels, (page239)

g calculate the implied growthrateinresidualincome,given the market bookratioandan estimateof the requiredrateofreturnonequity, (page240)

price-to-h explain continuing residualincome,and justifyanestimateof continuingresidualincomeattheforecasthorizon,givencompanyand industryprospects.

k describe accountingissues inapplying residualincomemodels,(page248)

1 evaluate whetherastockis overvalued,fairlyvalued,orundervalued basedon a

residualincomemodel,(page250)The topical coverage corresponds with thefollowing CFAInstituteassigned reading:

37 PrivateCompany ValuationThe candidate should be ableto:

a comparepublic and privatecompanyvaluation,(page264)

b describeusesof private businessvaluation,and explain applications ofgreatest

concerntofinancialanalysts, (page266)

c. explainvariousdefinitionsofvalue,and demonstrate how differentdefinitions

canleadtodifferentestimatesofvalue,(page267)

d explain theincome,market,and asset-based approachestoprivatecompanyvaluation andfactors relevanttothe selectionof each approach, (page268)

e. explain cash flowestimation issuesrelatedtoprivatecompanies and adjustmentsrequiredtoestimatenormalized earnings, (page269)

f calculate the value ofaprivatecompanyusing free cashflow,capitalized cashflow,and/orexcessearningsmethods,(page274)

g explain factors that require adjustment when estimating the discountrateforprivate companies,(page278)

h comparemodels usedtoestimatethe requiredrateofreturn toprivatecompanyequity(forexample, theCAPM,the expandedCAPM,and the build-upapproach), (page278)

i calculate the valueofaprivate company basedonmarket approachmethods,and describeadvantagesanddisadvantagesof eachmethod,(page280)

j describe the asset-based approachtoprivatecompanyvaluation,(page286)

k explain and evaluate the effectsonprivate company valuations of discounts andpremiums basedoncontrol and marketability, (page286)

1 describe the role of valuation standardsinvaluingprivate companies,(page290)

statements set forth by CFA Institute This topic is also covered in:

EQUITY VALUATION: APPLICATIONS AND

PROCESSES

StudySession 10

EXAM FOCUS

Thisreview issimplyanintroductiontothe process of equityvaluation andits

application Manyof theconceptsandtechniques introducedaredevelopedmorefully

insubsequent topicreviews.Candidates should be familiar with theconceptsintroduced

here,includingintrinsic value,analyst perception of mispricing, goingconcern versus

liquidationvalue,andthe differencebetween absolute andrelativevaluation techniques

LOS28.a:Define valuation andintrinsic value,and explainsourcesof

perceivedmispricing

CFA®ProgramCurriculum, Volume4,page 6Valuationisthe process ofdeterminingthevalueofan asset.Therearemanyapproaches

and estimatingthe inputs foravaluation modelcan be quitechallenging.Investment

success,however,candepend cruciallyonthe analyst’s abilitytodetermine the valuesof

securities

The generalstepsinthe equity valuationprocessare:

1 Understandthebusiness

2 Forecast companyperformance

3 Selecttheappropriate valuation model

4 Converttheforecastsintoavaluation

5 Apply the valuation conclusions

Whenwe usethetermintrinsicvalue(IV), we arereferringtothevaluationofan asset

orsecuritybysomeonewhohascomplete understandingof thecharacteristicsof the

asset orissuing firm.Totheextentthat stockpricesare notperfectly (informationally)

efficient,theymaydiverge from theintrinsicvalues

Analysts seekingtoproduce positive risk-adjustedreturnsdosoby tryingtoidentify

securities forwhichtheirestimateof intrinsicvalue differsfromcurrentmarket price

Oneframeworkdividesmispricingperceived bytheanalystinto twosources: the

difference betweenmarket priceandthe intrinsicvalue(actualmispricing) and the

difference between the analyst’sestimateofintrinsicvalue and actualintrinsicvalue

(valuationerror).Wecan representthis relationasfollows:

IVanalyst"PHce= (IVactual"PHce)+ "IVactual)

LOS28.b:Explainthe goingconcernassumption, andcontrastagoingconcern

valuetoaliquidation vtdue.

CFA®ProgramCurriculum,Volume4,page8The goingconcernassumptionissimply the assumption thatacompany willcontinue

to operate as abusiness,asopposedtogoingoutof business The valuation modelswewillcover areall basedonthe goingconcernassumption.An alternative,whenitcannot

be assumedthat the company willcontinueto operate(survive)as abusiness, isafirm’sliquidation value The liquidation valueistheestimateof what theassetsof the firmwould bring if sold separately,netof the company’s liabilities

LOS28.c:Describe definitionsofvalue,andjustifywhich definitionof valueis

mostrelevanttopublic company valuation

CFA®ProgramCurriculum,Volume4,page8

Asstatedearlier, intrinsicvalueisthemostrelevantmetricforananalyst valuing publicequities.However,other definitionsof valuemaybe relevantinothercontexts.Fairmarket valueisthe priceatwhichahypothetical willing,informed,and able sellerwould tradean asset to awilling,informed,and able buyer This definitionissimilar

totheconceptof fair value used for financial reportingpurposes Acompany’s marketprice should reflectitsfair market valueovertimeif the market has confidence that the

company’smanagementisactingintheinterestof equityinvestors

Investmentvalueisthe valueofastockto aparticular buyer.Investmentvaluemaydependonthe buyer’s specific needs and expectations,aswellasperceived synergies withexisting buyerassets.

When valuingacompany,ananalyst should beawareof thepurposeof valuation

Formostinvestment decisions, intrinsicvalueisthe relevantconceptof value.Foracquisitions,investmentvaluemaybemoreappropriate

LOS28.d: Describeapplicationsof equity valuation

CFA®ProgramCurriculum,Volume4,page 9

Professor’sNote:Thisissimplyalistofthe possiblescenariosthat mayformthebasisofanequity valuation question Nomatterwhat thescenariois, the toolsyouwillusearethesame

Valuationistheprocessof estimating the value ofan assetby(1)usingamodel based

onthe variables the analyst believes influence the fundamental value of theasset or

(2)comparingittothe observable market valueof “similar”assets.Equity valuationmodelsareused by analystsinanumberofways.Rather thananenduntoitself,valuationisatool thatisusedinthe pursuit of other objectives like those listedinthefollowing paragraphs

Stock selection Themostdirectuseof equity valuationistoguide thepurchase,

holding,orsaleof stocks Valuationisbasedonbothacomparison of theintrinsicvalue

of the stock withitsmarket price andacomparison ofitsprice withthat of comparable

stocks

Reading the market Current market prices implicitlycontaininvestors’ expectations

about thefuture value of the variables that influence the stocks price (e.g., earnings

growth andexpectedreturn).Analystscanestimatethese expectations by comparing

market prices withastock’sintrinsicvalue

Projecting the value ofcorporateactions.Many marketprofessionalsusevaluation

techniquestodetermine the valueof proposedcorporatemergers, acquisitions,

divestitures,managementbuyouts(MBOs),and recapitalization efforts

Fairnessopinions Analystsuseequity valuationto supportprofessional opinions about

the fairnessofapricetobe received by minority shareholdersinamergeroracquisition

Planning and consulting Many firmsengageanalyststoevaluate theeffects of proposed

corporatestrategiesonthe firm’s stock price, pursuing only those that have thegreatest

valuetoshareholders

Communicationwith analysts andinvestors.The valuation approach provides

management, investors,andanalysts withacommonbasis upon whichtodiscuss and

evaluate thecompany’sperformance,current state,andfuture plans

Valuationof private business Analystsusevaluation techniquestodetermine the value

of firmsorholdingsinfirms thatare notpublicly traded Investorsinnonpublic firms

relyonthese valuationstodetermine the valueof their positionsorproposed positions

Portfoliomanagement.While equity valuationcanbe consideredastand-alone function

inwhich the valueofasingle equity positionis estimated, it canbemorevaluable when

usedinaportfoliomanagement context todetermine the value and riskofaportfolio of

investments.Theinvestment process isusually consideredtohave threeparts:planning,

execution,and evaluation of results Equity valuationisaprimaryconcern inthe first

twoof thesesteps.

• Planning The firststepof theinvestment processincludes defininginvestment

objectivesandconstraintsand articulatingan investmentstrategyforselecting

securitiesbasedonvaluationparametersortechniques.Sometimes investors maynot

select individual equity positions, but the valuation techniquesareimpliedinthe

selectionofanindexorotherpresetbasketofsecurities Active investment managers

mayusebenchmarksasindicatorsof market expectations and then purposely deviate

incompositionorweightingtotake advantage of their differing expectations

• Executing theinvestmentplan The valuation of potentialinvestmentsguides the

implementation ofaninvestmentplan The results of the specified valuation

methods determine whichinvestmentswill be made and which will be avoided

LOS28.e:Describe questions that should be addressedinconductingan

industry and competitive analysis

CFA®ProgramCurriculum, Volume4,page12The five elementsof industrystructure asdeveloped by Professor MichaelPorter are:

1 Threatofnewentrantsinthe industry

2 Threatof substitutes

3 Bargainingpowerof buyers

4 Bargaining power of suppliers

5 Rivalry among existing competitors

Theattractiveness(long-term profitability) ofanyindustryisdeterminedby theinteractionof these five competitive forces(Porter’sfiveforces)

Professor’sNote:Thesefactorsarecoveredindetailin the topicreviewtitled

“TheFiveCompetitiveForcesthat Shape Industry.”Therearethree generic strategiesacompany mayemployinorderto competeand

generateprofits:

1 Costleadership: Being the lowest-cost producer of thegood

2 Productdifferentiation:Additionof product featuresor servicesthatincreasetheattractivenessof the firm’s productsothatitwill commandapremium priceinthemarket

3 Focus:Employingoneof the previous strategies withinaparticularsegmentof theindustryinordertogainacompetitive advantage

Once theanalyst has identifiedacompany’sstrategy,shecanevaluate theperformance ofthe businessovertime intermsof how wellitexecutesitsstrategyand how successfulit is

The basic building blocks ofequityvaluationcomefrom accounting informationcontainedinthe firm’sreportsand releases.Inorderfor the analysttosuccessfullyestimatethe valueof thefirm,the financialfactorsmustbe disclosedinsufficient detailandaccuracy.Investigating theissuesassociated with theaccuracyand detail ofafirm’sdisclosuresisoften referredto as aquality of financialstatementinformation.Thisanalysis requiresexaminationof the firm’sincomestatement,balancesheet,and the

notes tothe financialstatements.Studies have shown that the quality of earningsissue isreflectedinafirm’s stock price, with firms withmore transparentearningshaving highermarketvalues

Ananalystcanoften only discern important results ofmanagementdiscretionthrough

adetailedexaminationof the footnotes accompanying the financialreports.Quality ofearningsissuescanbe broken downintoseveral categories andmaybe addressed onlyinthefootnotes and disclosurestothe financialstatements.

Acceleratingor prematurerecognitionofincome.Firmshave usedavarietyof techniques

tojustifythe recognition ofincomebeforeittraditionally would have been recognized

These includerecordingsales andbillingcustomersbefore productsareshippedor

accepted and bill and hold schemesinwhichitemsarebilledinadvance and held

for future delivery These schemes have been usedtoobscure declinesinoperating

performance and boost reportedrevenueandincome

Reclassifyinggainsandnonoperatingincome.Firmsoccasionally have gainsorincome

fromsourcesthatareperipheraltotheir operations The reclassification of theseitemsas

operatingincomewill distort the resultsof the firm’s continuing operations, often hiding

underperformanceoradeclineinsales

Expenserecognitionand losses Delaying the recognition of expenses, capitalizing

expenses,and classifying operatingexpensesasnonoperatingexpenses isanopposite

approach that has thesameeffectasreclassifyinggains from peripheralsources,

increasing operatingincome.Management also has discretionincreating and estimating

reservesthat reflect expected futureliabilities,suchas abad debtreserveoraprovision

for expected litigation losses

Amortization,depreciation, and discountrates.Management hasa greatdealof discretion

inthe selectionofamortizationand depreciationmethods,aswellasthe choice of

discountratesindeterminationofpensionplan obligations These decisionscanreduce

thecurrentrecognition ofexpenses,ineffect deferring recognitiontolater periods

Off-balance-sheetissues.The firm’s balance sheetmaynotfully reflect theassetsand

liabilitiesof the firm Specialpurpose entities (SPEs)canbe used by the firmtoincrease

sales (by recording salestotheSPE) or toobscure thenatureand value ofassets or

liabilities Leasescanbestructuredasoperating, rather thanfinance,leasesinorderto

reduce the total liabilities reportedonthe balance sheet

LOS28.f: Contrast absolute and relative valuationmodels,and describe

examplesof eachtypeof model

CFA®ProgramCurriculum, Volume4,page22Absolute valuation models.Anabsolute valuation modelis onethatestimates anasset’s

intrinsic value,whichis itsvalue arising fromits investmentcharacteristics without

regardtothe valueof other firms.Oneabsolute valuation approachistodetermine the

valueofafirm todayasthe discountedor presentvalueof all the cash flows expectedin

thefuture Dividend discount modelsestimatethe valueofashare basedonthepresent

valueof all expected dividends discountedatthe opportunitycostof capital Many

analysts realize that equity holdersareentitledto morethan just the dividends andso

expand themeasureof cash flowtoinclude all expected cash flowtothe firm thatis

notpayabletoseniorclaims(bondholders,taxingauthorities,andsenior stockholders)

These models include thefree cash flow approach and the residualincomeapproach

Another absolute approachtovaluationisrepresented by asset-based models This

approachestimatesafirm’s valueasthesumof the market value of theassetsit ownsor

controls This approachiscommonly usedtovalue firms thatown orcontrol natural

resources,suchasoilfields,coal deposits, and other mineral claims

Relative valuation models Anotherverycommonapproachtovaluationistodeterminethevalueofanassetinrelationtothe valuesof otherassets.Thisisthe approachunderlying relative valuation models Themostcommonmodelsusemarket priceas a

multiple ofanindividual financialfactor of thefirm,suchasearningsper share Theresultingratio,price-to-earnings(P/E), iseasily comparedtothat of other firms.If theP/Eishigherthan that of comparablefirms, it issaidtoberelativelyovervalued,thatis,

overvalued relativetothe other firms(notnecessarily overvaluedonan intrinsicvaluebasis).Theconverse isalsotrue:if theP/E islower than that of comparablefirms,thefirmissaidtobe relatively undervalued

LOS28.g: Describesum-of-the-partsvaluation andconglomeratediscounts

CFA®ProgramCurriculum, Volume4,page25Rather than valuingacompanyas asingleentity,ananalystcanvalue individualparts

of the firm and add themuptodetermine the value for thecompanyas awhole Thevalue obtainediscalled thesum-of-the-partsvalue, or sometimesbreakupvalueorprivatemarket value This processisespecially useful when the companyoperatesmultipledivisions(orproductlines)with different business models and risk characteristics(i.e.,a

conglomerate)

Conglomerate discountisbasedonthe idea thatinvestorsapplyamarkdowntothe value

ofacompanythatoperatesinmultiple unrelatedindustries,comparedtothe valuea

company that hasasingle industry focus Conglomerate discountisthus theamountbywhich market value under-represents sum-of-the-parts value

Three explanations for conglomerate discountsare:

1. Internal capital inefficiency: Thecompany’sallocationof capitaltodifferent divisionsmaynothave been basedonsound decisions

2. Endogenous(internal)factors: For example, thecompany mayhave pursuedunre¬

lated business acquisitionstohide poor operating performance

3 Researchmeasurement errors:Somehypothesize that conglomerate discounts donot

exist,but ratherarearesultofincorrectmeasurement.

valuingagiven company

CFA®ProgramCurriculum, Volume4,page28

When selectinganapproach for valuingagivencompany,ananalyst should consider

whether the model:

• Fitsthe characteristicsof the company (e.g.,Does itpay dividends?Isearnings

growth estimable?Does ithave significant intangibleassets?).

• Isappropriate basedonthequality and availability of input data

• Is suitable given thepurposeof the analysis

Thepurposeof the analysismay be,for example, valuation for makingapurchase offer

foracontrollinginterest inthecompany.Inthiscase, amodelbasedoncash flowmay

bemoreappropriate thanonebasedondividends becauseacontrollinginterestwould

allow the purchaserto setdividend policy

Onethingtoremember withrespect tochoiceofavaluation modelisthat theanalyst

doesnothavetoconsider onlyone.Usingmultiple models and examining differences

inestimated valuescanreveal howamodel’s assumptions and the perspective of the

analysisareaffecting the estimated values

I KEY CONCEPTS

LOS28.a Intrinsicvalueisthevalueof anasset orsecurityestimatedbysomeonewho hascomplete understandingofthe characteristicsof theasset orissuing firm To theextent

that market pricesare notperfectly (informationally)efficient,theymaydiverge from

intrinsicvalue.Thedifferencebetween theanalyst’sestimateofintrinsicvalue andthecurrentprice ismadeup oftwo components:thedifference betweentheactualintrinsicvalue and the market price, and the difference between the actualintrinsicvalue and theanalyst’sestimateofintrinsicvalue:

Analyst“PHce = (IVactual"Price)+ “IVactual)

LOS28.bThe goingconcernassumptionissimply the assumption thatacompanywillcontinue

to operate as abusinessasopposedtogoingoutofbusiness.The liquidation valueistheestimateofwhattheassetsof thefirm would bring if sold separately,netof thecompany’s liabilities

LOS28 c

Fairmarketvalueisthepriceatwhichahypothetical willing,informed,and ablesellerwould tradean asset to awilling, informed and able buyer.Investmentvalueisthevalueto aspecific buyer after includinganyadditionalvalue attributabletosynergies

Investmentvalueis anappropriatemeasure forstrategicbuyerspursuingacquisitions

LOS 28.dEquity valuationisthe process ofestimatingthevalueofan assetby(1) usingamodelbasedonthe variables theanalyst believes influencethefundamental valueof theasset

or(2)comparingittothe observable market valueof“similar”assets.Equity valuationmodelsareusedby analystsinanumberofways.Examples include stockselection,readingthemarket,projecting thevalueofcorporate actions,fairnessopinions, planningand consulting,communicationwith analysts andinvestors,valuationof privatebusiness,and portfoliomanagement.

LOS28 eThe five elementsof industrystructure asdeveloped by Professor MichaelPorterare:

1 Threatofnew entrantsin theindustry

2 Threatof substitutes

3 Bargaining power ofbuyers

4 Bargainingpowerof suppliers

5 Rivalryamongexistingcompetitors

Quality of earningsissuescanbe broken downintoseveral categories andmaybe

addressedonlyin thefootnotes and disclosurestothe financialstatements:

• Acceleratingorprematurerecognition ofincome

• Reclassifying gains and nonoperatingincome

• Expense recognition and losses

• Amortization,depreciation, and discountrates.

• Off-balance-sheetissues

LOS 28.f

Anabsolute valuation modelis onethatestimatesanasset’sintrinsicvalue (e.g., the

discounted dividend approach) Relative valuation modelsestimateanasset’sinvestment

characteristics comparedtothe valueof other firms (e.g., comparingP/E ratiostothose

of other firmsinthe industry)

LOS 28.g

Sum-of-the-parts valuationisthe process of valuing the individualcomponentsof

acompany and then adding these values togethertoobtain the valueof the whole

company.Conglomerate discount referstotheamountby which market priceislower

than the sum-of-the-parts value Conglomerate discountis anapparentprice reduction

applied by the marketstofirms thatoperateinmultiple industries

LOS28.h

When selectinganapproach for valuingagivencompany,ananalyst should consider

whether the model fits the characteristics of thecompany, isappropriate basedonthe

quality and availability of inputdata,andis suitable,given thepurposeof the analysis

CONCEPT CHECKERS

SusanWeiber, CFA,has noted thatevenher bestestimatesofastocksintrinsicvaluecandiffer significantly from thecurrentmarket price The least likelyexplanationis:

A differences between herestimateand the actualintrinsicvalue

B differences between the actualintrinsicvalue and the market price

C differences between theintrinsicvalue and the goingconcernvalue

Anappropriate valuationapproach foracompanythatisgoingoutof businesswould betocalculateits:

A residualincomevalue

B dividend discount model value

C liquidation value

Davy Jarvis,CFA, isperforminganequity valuationas partof the planning andexecutionphase of the portfoliomanagementprocess Hisresults will also beusefulfor:

A communicationwith analysts andinvestors

B technicalanalysis

C benchmarking

The five elementsof industrystructure, asoutlined by MichaelPorter,include:

A the threatof substitutes

B product differentiation

C costleadership

Tom Walder has been instructedto useabsolute valuationmodels,andnot

relative valuationmodels, inhis analysis Which of the followingisleast likelyto

beanexample ofanabsolute valuation model? The:

A dividend discount model

B price-to-earnings marketmultiple model

C residualincomemodel

6 DavyJarvis, CFA, isperforminganequity valuation andreviewshisnotes

for key points he wantedtocoverwhen planning the valuation.Hefinds thefollowing questions:

• Doesthecompany paydividends?

• Isearningsgrowth estimable?

• Doesthe company have significant intangibleassets?

Whichof thefollowinggeneral questionsisJarvistryingtoanswerwhenplanning this phase of the valuation?

A Doesthe model fit the characteristics of theinvestment?

B Isthe model appropriate basedonthe availability of input data?

C Canthe model be improvedtomakeit more suitable,given thepurposeofthe analysis?

Usethe following informationto answerQuestions 7and8.

SunPharmaisalarge pharmaceutical company basedin SriLanka that manufactures

prescription drugs under license from large multinationalpharmaceutical companies

DelengaMahamurthy, CEO of SunPharma, isevaluatingapotential acquisition of

IslandCookware,asmall manufacturing company that produces cooking utensils

Mahamurthy feels that Sun Pharma’s excellent distribution network could add valueto

Island Cookware Sun Pharma planstoacquire Island Cookware for cash Several days

later,SunPharmaannouncesthat they have acquired Island Cookwareatmarket price

Sun Pharma’smostappropriatevaluation for Island Cookwareis its:

A sum-of-the-parts value

B investmentvalue

C liquidation value

7

Uponannouncementof the merger, the market price of Sun Pharma drops This

ismostlikelyaresultof the:

A unrelated business effect

B taxeffect

C conglomerate discount

8

ANSWERS - CONCEPT CHECKERS

o

§ 1 C The difference between the analyst’s estimate of intrinsic value and the current price is

made up of two components:

C Theliquidationvalue is the estimate of what the assets of thefirmwillbringwhen sold

separately,net of thecompany’sliabilities.Itis most appropriate because the firm is not

a going concernand willnot paydividends.Theresidualincomemodelis based on the going concern assumption and is not appropriate forvaluingafirmthat isexpectedto

go out of business.

to

3 A Communication withanalystsand investors is one of the common uses of an equity valuation Technical analysis andbenchmarkingdo not require equity valuation.

4 A The five elements of industry structure asdevelopedby Professor Michael Porter are:

1 Threat of new entrants in the industry.

2 Threat of substitutes.

3 Bargaining power ofbuyers

4 Bargaining power ofsuppliers

5 Rivalry among existing competitors.

5 B Absolute valuation models estimate value as some function of the present value of future cash flows(e.g.,dividend discount and free cash flow models) or economicprofit (e.g.,

residual income models).Relativevaluation models estimate anasset’svaluerelative

to the value of other similar assets The price-to-earnings marketmultiple modelis anexampleof a relative valuation model.

6 A Jarvisis mostlikelytrying to be sure theselected modelfits the characteristics of the

investment Model selection willdependheavily on the answers to these questions.

7 B The appropriate valuation for Sun Pharma’s acquisition is the investment value, which incorporates the value of any synergies present in the acquisition.Sum-of-the-parts

value is notapplicable,as thevaluation doesnot require separatevaluationof different

divisionsofIslandCookware.Liquidation valueisalsonot relevant, as Sun Pharmadoes

not intend toliquidatethe assets of Island Cookware.

8 C Upon announcement of the acquisition, the market price of Sun Pharma should not

changeif the acquisition was at fair value However, the market isvaluingthe whole company at a value less than the value of its parts: this is aconglomeratediscount.

We are not given any informationabouttax consequences of the mergerandhence

a tax effect isunlikelyto be the cause of the market pricedrop.The acquisition of

an unrelated business may result in aconglomeratediscount, but there is no defined

‘unrelated business effect.’

statements set forth by CFA Institute This topic is also covered in:

RETURN CONCEPTS

Study Session 1 0

EXAM FOCUS

Muchof this material buildson conceptscovered elsewhereinthe LevelIIcurriculum

Beabletodistinguishamongreturn conceptssuchasholdingperiodreturn,realized

return,expectedreturn,requiredreturn,anddiscountrate.Understand theconceptof

convergence of priceto intrinsicvalue.Beabletoexplainthe equity risk premium,the

variousmethods and models usedtocalculate theequityriskpremium,and the strengths

and weaknessesof those methods Thereviewalsocoversthe weightedaveragecostof

capital(WACC).Youmustbe abletoexplain and calculatetheWACCandbeableto

selectthemostappropriatediscountrateforagiven cash flowstream.

LOS29.a:Distinguishamong realizedholding periodreturn,expected holding

periodreturn,requiredreturn, returnfromconvergenceof pricetointrinsic

value,discountrate,andinternalrateofreturn.

CFA®ProgramCurriculum, Volume4,page 49

HoldingPeriod Return

Holding periodreturn istheincreasein price ofan assetplusanycash flow received

fromthatasset,divided by the initialpriceoftheasset.Themeasurement orholding

periodcanbeaday,amonth,ayear,andso on.Inmost cases, we assumethe cash flow

isreceivedatthe endof the holding period, and theequationfor calculating holding

periodreturn is:

Pt-Po+Cfi P.+Cfi

The subscript1simply denotesoneperiod from today P stands for price andCFstands

for cash flow.Forashareofcommon stock, wemightthink of this intermsof:

I If the cash flowisreceived before the endof the period, thenCFjwould equal the cash

flow receivedduring the periodplusanyinterestearnedonthereinvestmentof the cashflowfrom thetime it wasreceived untiltheendof themeasurementperiod

Inmost cases,holding periodreturns areannualized.Forexample, ifthereturnforone

month is 1% (0.01), then theanalyst mightreport anannualized holding periodreturn

of(1 +0.01)12- 1=0.1268or12.68% Annualizedholdingperiodreturnsshould bescrutinizedtomakesurethatthereturnforthe actual holding period trulyrepresents

whatcouldbeearnedforan entireyear

Realized andExpected HoldingPeriodReturn

Arealizedreturn is ahistoricalreturnbasedonpastobservedpricesandcash flows

Anexpectedreturn isbasedonforecasts of futurepricesandcashflows Suchexpected

returns canbe derivedfrom elaborate modelsorsubjective opinions

RequiredReturn

Anasset’srequiredreturnistheminimumreturn aninvestorrequires given the asset’srisk Amoreriskyassetwill haveahigher requiredreturn.Requiredreturnisalsocalledthe opportunitycostfor investing in theasset.If expectedreturn is greater (less) thanrequiredreturn,theasset isundervalued(overvalued).

PriceConvergence

Iftheexpectedreturnisnotequaltorequiredreturn,therecan bea“returnfromconvergenceof pricetointrinsicvalue.” LettingVQdenote thetrueintrinsic value,andgiventhat pricedoesnotequalthat value(i.e.,VQ P(J),then thereturnfromconvergence of priceto intrinsicvalueis(Vfl — PQ)/Pf|.Ifananalystexpectsthe price oftheasset toconvergeto its intrinsicvaluebythe endof thehorizon,then(V0—PQ) /Pfl

isalso the difference betweentheexpectedreturn on an assetanditsrequiredreturn:

(VQ-PQ)expectedreturn=requiredreturn+

Po

Itispossiblethattherearechronic inefficienciesthat impedeprice convergence

Therefore,evenifananalyst feels thatVQ P(Jforagivenasset,theconvergenceyieldmaynotbe realized

DiscountRateThe discountrate istherateusedtofindthepresentvalueofan investment.Whileit

ispossibleto estimate adiscountratesubjectively,amuch sounder approachis to use a

market determinedrate.

Internal Rate of Return

Forpublicly tradedsecurities,the internalrateofreturn(IRR) isamarket-determined

rate.Itistheratethatequatesthe value of the discounted cash flowstothecurrentprice

of the security If marketsare efficient,then the IRRrepresentsthe requiredreturn.

LOS 29.b: Calculate and interpretanequity risk premium using historical and

forward-lookingestimationapproaches.

CFA®ProgramCurriculum, Volume4,page 54

The equity risk premiumisthereturninexcessof the risk-freeratethatinvestors

require forholdingequitysecurities.Itisusually definedasthe difference between the

requiredreturnonabroadequitymarket index and the risk-freerate:

equity riskpremium=requiredreturnonequity index-risk-freerate

An estimateofafuture equity risk premium, basedonhistoricalinformation,requires

the following preliminarysteps:

• Selectanequity index

• Selectatimeperiod

• Calculate themeanreturnonthe index

• Selectaproxyfor the risk-freerate.

The risk-freereturnshould correspondtothetimehorizonfor theinvestment

(e.g., T-bills for shorter-term and T-bonds for longer-termhorizons).The broad market

equity risk premiumcanbe usedtodetermine the requiredreturnfor individual stocks

using beta:

requiredreturnfor stockj=risk-freereturn +(3jx(equity risk premium)

where:

(3j = the “beta”of stock j andserves asthe adjustment for the level of systematic

risk inherentinthe stock

If thesystematicriskof stock j equals that of themarket,then (3-=1.Ifsystematicriskis

greater(less)than that of themarket,then |3.>1(<1).Amoregeneral representationis:

requiredreturnfor stock j=risk-freereturn +(equity risk premium) +other risk

premia/discounts appropriate for j

The general modelisusedinthe build-up method(discussed later)andistypically used

for valuation of private businesses It doesnot accountforsystematicrisk

Notethatanequity risk premiumis anestimated value andmaynotberealized Also

keepinmind that theseestimatescanbe derivedinseveralways Ananalyst readinga

reportthat discussesa“risk premium” should takenote to seehow the authorof the

reporthas arrivedatthe estimated value

Professor’sNote:Asyouwork through thistopicreview,keepinmind that theriskpremiums, including the equity riskpremium,aredifferencesin rates—

typicallyamarketrateminustherisk-freerate.

ESTIMATESOF THEEQUITY RISK PREMIUM: STRENGTHSANDWEAKNESSES

Therearetwo typesofestimatesof the equity risk premium: historicalestimatesandforward-lookingestimates

HISTORICAL ESTIMATES

Ahistoricalestimateof the equity risk premiumconsistsof the difference between thehistoricalmeanreturnforabroad-based equity-market index andarisk-freerateover

agiventimeperiod.Itsstrengthis itsobjectivity andsimplicity.Also,ifinvestorsare

rational,then historicalestimateswill be unbiased

Aweaknessof the approachisthe assumption that themeanandvarianceof thereturnsareconstantovertime (i.e.,that theyarestationary) This doesnotseemtobethecase.

In fact,the premium actually appearstobe countercyclical—it islow during goodtimesand high during badtimes Thus,ananalyst using this methodtoestimatethecurrent

equity premiummustchoose the sample period carefully The historicalestimatecan

also beupward biased if only firms that have survivedduringthe period ofmeasurement(calledsurvivorshipbias)areincludedinthe sample

Other considerations include the methodfor calculating themeanand which risk-free

rateismostrelevanttothe analysis.Becauseageometricmean isless thanorequalto

the corresponding arithmeticmean,the risk premium will always be lower when thegeometricmeanisused instead of the arithmeticmean.If the yieldcurve isupwardsloping, theuseof longer-term bonds rather than shorter-term bondstoestimatetherisk-freeratewillcausethe estimated risk premiumtobe smaller

Gordon Growth Model

Theconstantgrowth model(a.k.a.the Gordon growthmodel)isapopular methodto

generateforward-lookingestimates.The assumptions of the modelarereasonable whenappliedtodevelopedeconomiesandmarkets,wherein therearetypicallyamplesources

of reliable forecasts for data suchasdividendpaymentsandgrowthrates.This methodestimatesthe riskpremiumasthe expected dividend yield plus the expected growthrateminusthecurrentlong-termgovernmentbond yield

GGM equity risk premium= (1-year forecasted dividendyieldonmarketindex)+

(consensuslong-term earnings growthrate)-(long-termgovernmentbondyield)

Denoting eachcomponentby(Dj/ P), g,andrLT0,respectively, the forward-looking

equity risk premiumestimate is:

(Dj/P) + g -rLT0

Aweaknessof the approachisthat the forward-lookingestimateswill change through

timeand needtobe updated Duringatypicaleconomic boom,dividendyieldsarelow

and growth expectationsarehigh, while the oppositeisgenerallytruewhen theeconomy

isless robust.Forexample,supposethat duringaneconomicboom(bust)dividend

yieldsare2% (4%),growth expectationsare6%(3%),and long-term bond yieldsare

6%(3%).The equity risk premia during thesetwodifferent periods would be2%

during the boom and 4% during the bust.And,ofcourse,thereisno assurancethat the

capital appreciation realized will be equaltothe earnings growthrateduring the forecast

period

Another weaknessisthe assumption ofastable growthrate,whichisoftennot

appropriateinrapidly growingeconomies.Sucheconomiesmighthave threeormore

stagesof growth: rapid growth,transition,andmaturegrowth.Inthiscase,another

forward-lookingestimatewouldusethe requiredreturn onequity derived from the IRR

from the following equation:

equity index price=PVrapid(r)+PVtransition(r)+PVmature(r)

where:

PVrapid

PVtransition

=presentvalueof projected cash flows during the rapid growthstage

=presentvalueof projected cash flows during the transitional growth

stage

=presentvalueof projected cash flows during thematuregrowthstage

PV

The forward-lookingestimateof the equity premium would be therfrom this equality

minusthe correspondinggovernmentbondyield

Supply-SideEstimates (Macroeconomic Models)

Macroeconomicmodelestimatesof the equity risk premiumarebasedonthe

relationships betweenmacroeconomicvariables and financial variables.Astrength of this

approachistheuseofprovenmodels andcurrentinformation.Aweaknessisthat the

estimatesareonly appropriate for developedcountrieswhere public equitiesrepresent

arelatively large share of theeconomy,implying thatit isreasonabletobelieve there

should besomerelationship betweenmacroeconomicvariables andassetprices

Onecommonmodel[Ibbotson-Chen (2003)]forasupply-sideestimateof the riskpremiumis:

equity risk premium= [1+i]X[1+rEg]x[1+PEg]—1+Y—RFwhere:

i = expected inflationrEg = expected real growthinEPS

PEg = expected changesintheP/E ratio

Y = the expected yieldonthe index

RF = the expected risk-freerateThe analystmustdetermine appropriate techniques with whichto computevalues forthese inputs For example,amarket-basedestimateof expected inflationcanbederivedfrom the differencesintheyields for T-bonds andTreasury Inflation ProtectedSecurities(TIPS)having comparablematurities:

i =(YTMof20-year T-bonds) - (YTMof20-year TIPS)

Professor’sNote:TIPSareinflation-indexedbonds issuedbythe U.S Treasury

TIPSpayinterest every sixmonths andprincipalatmaturity Thecouponandprincipalareautomatically increased by theconsumerprice index(CPI)

Expected real growthinEPSshould be approximately equaltothe real GDP growth

rate.GrowthinGDPcanbe estimatedasthesumof labor productivity growth andgrowthinthe labor supply:

rEg =realGDPgrowthrEg =labor productivity growthrate +labor supply growthrate

The PEg would dependuponwhether the analyst thought the marketwasoverorundervalued If the marketisbelievedtobeovervalued, P/E ratioswould be expectedto

decrease (PEg<0) and the opposite would betrueif the marketwerebelievedtobeundervalued (PEg>0).If the marketiscorrectly priced, PEg=0.The Y canbeestimated using estimated dividendsonthe index (includingreinvestmentreturn)

SurveyEstimatesSurveyestimatesof the equity risk premiumusetheconsensusof the opinions from

asample of people If the sampleisrestrictedtopeople whoareexpertsintheareaofequityvaluation,the resultsarelikelytobemorereliable The strengthisthatsurveyresultsarerelativelyeasytoobtain The weaknessis that,evenwhen thesurvey isrestrictedto expertsinthearea,therecanbeawide disparity between theconsensusesobtainedfrom different groups

LOS 29.c:Estimatetherequiredreturnonanequityinvestmentusing the

capitalassetpricingmodel,the Fama-Frenchmodel,the Pastor-Stambaugh

model, macroeconomicmultifactor models,and thebuild-upmethod(e.g.,

bond yieldplus riskpremium).

CFA®ProgramCurriculum, Volume4,page67

CapitalAssetPricing Model

The capitalassetpricing model(CAPM)estimatesthe requiredreturnonequityusing

the following formula:

requiredreturnonstock j=risk-freerate + (equity risk premiumxbetaof j)

Example: UsingtheCAPMtocalculatetherequiredreturn onequity

Thecurrentexpected risk-freerateis 4%,the equity risk premiumis3.9%,and the

betais 0.8.Calculatethe requiredreturn onequity

Answer:

7.12%=4%+ (3.9% x 0.8)

Multifactor Models

Multifactor modelscanhavegreaterexplanatorypowerthan theCAPM,whichisa

single-factor model The general form ofan multifactor modelis:

requiredreturn=RF+(riskpremium)j + (riskpremium)2+ +(riskpremium)n

(riskpremium); =(factorsensitivity);x (factorriskpremium);

Thefactor sensitivityisalso called thefactorbeta,andit isthe asset’s sensitivityto a

particularfactor,all else being equal The factor risk premiumisthe expectedreturn

above the risk-freeratefromaunit sensitivitytothefactor andzerosensitivitytoall

otherfactors

Rbig) = asmall-capreturnpremiumequaltothe averagereturnon

small-cap portfoliosminusthe averagereturnonlarge-capportfolios

RLBM) = a vaÿue returnpremiumequaltotheaveragereturn onhigh

book-to-market portfoliosminusthe averagereturn onlowbook-to-market portfolios

Example: Applying theCAPMand the Fama-French ModelSupposewederive the following factor values from market data:

Weestimatethat stock j hasaCAPMbetaequalto1.3.Stock jis asmall-cap growth

stockthat hastradedat alow booktomarket inrecentyears Using the Fama-French

model,weestimatethe following betas for stock j:

ThePastor-Stambaughmodeladdsaliquidityfactortothe Fama-Frenchmodel.The

baseline valuefor theliquidity factor betais zero.Lessliquidassetsshould havea

positive beta,whilemoreliquidassetsshould haveanegative beta

Example: ApplyingthePastor-Stambaugh model

Assumealiquidity premium of4%,thesamefactor riskpremiumsasbefore,and the

followingsensitivitiesforstock k:

MacroeconomicMultifactor Models

Macroeconomicmultifactor modelsusefactors associated witheconomicvariables that

canbe reasonably believedtoaffect cash flows and/or appropriate discountrates.The

Burmeister,Roll,andRossmodel incorporates thefollowingfivefactors:

1 Confidencerisk: unexpected changeinthe difference between thereturnof risky

corporatebonds andgovernmentbonds

2. Timehorizon risk: unexpected changeinthe difference between thereturnoflong-termgovernmentbonds andTreasury bills

3 Inflationrisk:unexpectedchangeinthe inflationrate.

4 Businesscycle risk:unexpected changeinthe levelof real business activity

5 Market timing risk: the equity marketreturnthatisnotexplained by the other fourfactors

Aswith the othermodels,to computetherequiredreturnonequity foragivenstock,thefactor valuesaremultiplied byasensitivitycoefficient(i.e., beta)for thatstock;theproductsaresummed and addedtothe risk-freerate.

Example: Applyingamultifactor modelImagine thatwe aregiven thefollowing values for the factors:

confidence risktimehorizon risk = 3.0%

inflation riskbusiness cyclerisk = 1.6%

market timing risk = 3.4%

Suppose thatwe arealso given the followingsensitivitiesfor stock j:0.3, -0.2, 1.1, 0.3, 0.5,respectively Using the risk-freerateof3.4%,calculate the requiredreturn

usingamultifactor approach

The build-up methodissimilartothe risk premium approach Itisusually applied

toclosely held companies where betasare notreadily obtainable.Onepopularrepresentationis:

requiredreturn=RF+equity risk premium+sizepremium+specific-company

premium

Thesizepremium would be scaledupordown basedonthesizeof thecompany.

Smaller companies would havealarger premium

As before,computing therequiredreturnwould bea matterof simply addingupthe

valuesinthe formula Some representationsuseanestimated betatoscale thesizeof the

company-specific equity risk premium but typicallynotfor the other factors

The formula could haveafactor for the level of controllingversus minority interestsand

afactor for marketability of the equity;however,these lattertwofactorsareusually used

toadjust the value of thecompanydirectly rather than through the requiredreturn.

Bond-Yield Plus RiskPremiumMethod

The bond-yield plus risk premium methodisabuild-up method thatisappropriate if

thecompanyhas publicly traded debt The method simply addsarisk premiumtothe

yieldtomaturity(YTM)of thecompany’slong-term debt The logic hereisthat theyield

tomaturityof thecompany’sbonds includes theeffects ofinflation,leverage, and the

firm’ssensitivitytothe business cycle Because thevariousriskfactorsarealready taken

intoaccountintheYTM,the analystcansimply addapremium for the added risk

arising fromholding the firm’s equity That valueisusually estimatedat 3-5%,with the

specificestimatebased uponsomemodelorsimply from experience

Example: Applying the bond-yield plus riskpremiumapproach

CompanyLMNhas bonds with 15yearstomaturity.They haveacoupon of8.2%

andapriceequalto101.70.Ananalystestimatesthat the additional risk assumed

fromholdingthefirm’s equity justifiesariskpremium of3.8% Giventhecouponand

maturity,the YTMis8%.Calculate thecostof equity using the bond-yield plus risk

premiumapproach

Answer:

costof equity= 8%+3.8% = 11.8%

Professor’sNote:Althoughmostofourexamplesinthissectionhavefocusedon

the calculationofthereturn usingvariousapproaches, don’t lose sightofwhat

informationthecomponentsofeach equation mightconvey.The betas tell

usabout the characteristicsoftheassetbeingevaluated,and the risk premiatellushow those characteristicsarepricedinthe market.Ifyouencountera

situation ontheexamwhereyou areaskedtoevaluate style and/or the overallimpactofacomponent on return, separate outeachfactoranditsbeta—paying

carefulattentiontowhether thereisapositiveornegativesign attachedtothe

component—and work throughitlogically

LOS 29.d:Explainbetaestimationforpubliccompanies,thinlytradedpublic

companies, andnonpubliccompanies

CFA®ProgramCurriculum, Volume4,page68

BetaEstimatesfor Public Companies

Uptothis point,wehave concerned ourselves with methodsfor estimating the equityrisk premium Nowwe turnour attentiontotheestimationofbeta,themeasureof thelevelofsystematicrisk assumedfrom holding the security.Forapubliccompany, ananalystcancomputebetaby regressing thereturnsof thecompany’sstockonthereturns

of the overall market.To doso,theanalystmustdetermine which indextouse intheregression and thelengthandfrequency of the sample data

Popular choices for the index include theS&P500 and theNYSEComposite Themostcommonlength and frequencyarefiveyearsof monthly data.Apopular alternativeistwoyearsof weeklydata,whichmaybemoreappropriate for fast-growing markets

AdjustedBetafor Public Companies

When making forecasts of the equity risk premium,someanalysts recommend adjustingthe betafor beta drift.Betadriftreferstothe observed tendency ofanestimated betato revert to avalue of1.0overtime.Tocompensate, anoften-used formulatoadjust theestimateof betais:

adjusted beta=(2/3 x regressionbeta) + (1/3 x 1.0)

Example: Calculating adjusted betaSupposethatananalystestimatesabetaof0.8using regression and historical dataand adjusts the betaasdescribed previously Calculate the adjusted beta anduseittoestimateaforward-lookingrequiredreturn.

adjusted beta=(2/3 xregressionbeta) + (1/3 x 1.0)= (2/3 x 0.8) + (1/3 x 1.0)=

0.867

Notethat this adjusted betaisclosertoonethan the regression beta

If the risk-freerateis4% and the equity risk premiumis3.9%,then the required

returnwould be:

requiredreturn onstock=risk-freerate +(equity risk premiumxbetaofstock)=

4%+ (3.9% x0.867)=7.38%

Notethat the requiredreturnishigher than the7.12%derived using the unadjusted

beta Naturally, thereareother methods for adjusting betato compensatefor beta

drift Statisticalservicesselling financial information often reportboth unadjusted and

adjusted beta values

Professor’sNote: Note thatsomestatisticalservicesusereversiontoapeermeanrather thanreversion to one.

BetaEstimatesforThinlyTraded Stocks andNonpublicCompanies

Betaestimationforthinly traded stocks and nonpubliccompaniesinvolvesa4-step

procedure If ABCisthe nonpubliccompanythestepsare:

Step1: Identifyabenchmarkcompany,whichispublicly traded and similartoABCin

itsoperations

Step2: Estimatethe betaof that benchmarkcompany,whichwewill denote XYZ This

canbe done witharegressionanalysis

Step 3: Unlever the betaestimatefor XYZ with the formula:

1

unlevered betaforXYZ= (betaofXYZ)x

debtofXYZequity of XYZStep 4: Leverup the unlevered beta for XYZ using the debt and equitymeasuresof ABC

to getan estimateofABC’s beta for computing the requiredreturnonABC’sequity:

debtof ABCestimateof beta forABC = (unleveredbetaofXYZ)X1+

equity of ABC

Professor’sNote:The unleveringprocessisolates systematic risk ItassumesthatABC’sdebtishigh grade It alsoassumesthat themixofdebt and equityinthecapitalstructure stays atthetargetweights

The procedureisthesameif ABCisathinly tradedcompany.With the betaestimateforABCin hand,the analyst would thenusethat valueinthe CAPM.

LOS 29.e:Describestrengthsand weaknessesof methods usedtoestimatethe

requiredreturnonanequityinvestment

CFA®ProgramCurriculum, Volume4,page 67

The CAPM has the advantage of beingverysimpleinthatit usesonlyonefactor Theweaknessischoosing the appropriate factor Ifastock tradesinmorethanonemarket,for example, therecanbemorethanonemarketindex,and thiscanleadtomorethanone estimateof requiredreturn.Another weaknessislow explanatory powerinsome

cases.

Astrength of multifactor modelsisthatthey usually have higher explanatory power, butthisisnotassured Multifactor models have the weakness of beingmorecomplex andexpensive

Astrengthof build-up modelsisthat theyaresimple andcanapplytoclosely heldcompanies The weaknessisthatthey typicallyusehistorical valuesasestimatesthatmay

ormaynotbe relevantto currentmarket conditions

LOS 29.f:Explaininternational considerationsinrequiredreturnestimation

CFA®ProgramCurriculum, Volume4,page 85Additional considerations when investing internationally include exchangeraterisk anddataissues.Theavailability of good datamaybeseverely limitedin somemarkets.Notethat theseissuesareof particularconcern inemerging markets

Internationalinvestment,ifnothedged, exposes theinvestortoexchangeraterisk.To

compensatefor anticipated changesinexchangerates, ananalyst shouldcomputetherequiredreturninthe homecurrencyand then adjustitusing forecasts forchanges

intherelevantexchangerate.Twomethodsforbuildingriskpremia intothe required

returnarediscussedinthe following

CountrySpreadModel

Onemethodfor adjusting data from emerging marketsisto use acorrespondingdeveloped marketas abenchmark and addapremium for the emerging market.Onepremiumtouse isthe difference between the yieldonbondsinthe emerging marketminusthe yieldoncorrespondingbondsinthe developed market

Country Risk Rating Model

Asecond methodisthecountryrisk rating model This modelestimatesaregressionequation using the equity risk premium fordevelopedcountriesasthe dependent

variable and risk ratings (published by InstitutionalInvestor)for thosecountriesasthe

independent variable Once the regression modelisfitted(i.e., weestimatethe regression

coefficients),the modelisthen usedfor predicting the equityriskpremium(i.e.,

dependentvariable)for emerging markets using the emerging markets risk-ratings(i.e.,

with capital The suppliers of capitalareequityinvestorsand those who lendmoneyto

thecompany Anoften-usedmeasure isthe weightedaveragecostof capital(WACC) :

WACC=

market valueof equitymarket valueof debt

market valueof debt and equity market valueof debt and equity

Inthis representation,rdandrearethe requiredreturn ondebt and equity, respectively

Inmany markets,corporationscantakeadeduction forinterest expense.The inclusion

of theterm (1-tax rate)adjuststhecostof the debtsoit is on anafter-tax basis.Since

themeasureshould be forward-looking, thetax rateshould be the marginaltax rate,

which better reflects thefuturecostof raising funds.Formarkets whereinterestexpense

isnotdeductible,the relevanttax ratewould bezero,and thepre-andafter-taxcostof

debt wouldbeequal

WACCisappropriate for valuingatotal firm To obtain the value of equity, firstuse

WACCtocalculate the valueofafirm and then subtract the marketvalue of long-term

debt.Wetypicallyassumethat the market value weights of debt and equityareequalto

theirtargetweights When thisisnotthecase,the WACC calculation shouldusethe

targetweights for debt and equity

LOS29.h:Evaluate the appropriateness of usingaparticularrateofreturnasa

discountrate,givenadescription of the cash flowto bediscounted and other

relevantfacts

CFA®ProgramCurriculum, Volume4,page88The discountrateshould correspondtothetypeof cash flow being discounted Cash

flowstotheentirefirm should be discounted with the WACC Alternatively, cash flows

inexcessof whatisrequired for debtserviceshould be treatedascash flowstoequity

and discountedatthe requiredreturn toequity

Ananalystmaywishtomeasurethepresentvalueof real cashflows,andareal discount

rate(i.e.,onethat has been adjusted for expectedinflation)should be usedinthatcase.

Inmost cases,however,analysts discount nominal cash flows with nominal discount

rates.

holding periodreturn=r= Pl~P°+Cÿ = -1

Anasset’srequiredreturn istheminimumexpectedreturnan investor requiresgiventhe asset’s characteristics

If expectedreturn is greater(less) thanrequiredreturn,theassetisundervalued

(overvalued).Themispricing canleadto a returnfrom convergence of priceto

intrinsicvalue

The discountrateisa rateusedtofind thepresentvalueofaninvestment

The internalrateofreturn (IRR) istheratethatequatesthe discounted cash flows

tothecurrentprice.Ifmarketsareefficient, then the IRRrepresentstherequired

return.

LOS 29.bThe equity risk premiumisthereturnover therisk-freeratethatinvestors require forholding equitysecurities.Itcanbe usedtodetermine the requiredreturnfor specificstocks:

requiredreturnforstock j=risk-freereturn +(3jxequityriskpremiumwhere:

(3j = the “beta”of stock jandservesastheadjustmentfor the level of systematic risk

Amoregeneralrepresentationis:

requiredreturnfor stockj=risk-freereturn +equityriskpremium+other

adjustments forj

A historicalestimateof the equity risk premiumconsistsofthedifference betweenthe

mean return on abroad-based,equity-market index andthemean return on

U.S.Treasurybills overagiventimeperiod

Forward-lookingor ex ante estimates use currentinformationandexpectationsconcerningeconomicand financial variables.Thestrength ofthismethodisthat itdoes

notrelyon anassumption ofstationarityandisless subjecttoproblems like survivorshipbias

Therearethreetypesof forward-lookingestimatesof the equity risk premium:

• Gordongrowth model

• Macroeconomic models,whichuse currentinformation,butareonly appropriate

for developedcountrieswhere public equitiesrepresent arelatively large share of the

GGM equity risk premium=1-yearforecasted dividend yieldonmarket index+

consensuslong-term earnings growthrate-long-termgovernmentbondyield

= market risk premium

• The Pastor-Stambaugh model addsaliquidity factortothe Fama-French model

• Macroeconomicmultifactor modelsusefactors associated witheconomicvariables

that would affect the cash flows and/or discountrateof companies

• The build-up methodissimilartothe risk premium approach.Onedifferenceis

that this approach doesnot usebetastoadjustfor theexposureto afactor The bond

yield plus risk premium methodisa typeof build-up method

Beta estimation:

• Aregression of thereturnsofapublicly traded company’s stockreturnsonthereturnsofanindex providesan estimateof beta.Forforecastingrequiredreturnsusing theCAPM,ananalystmaywishtoadjust for beta drift usinganequation suchas:

adjusted beta=(2/3xregressionbeta)+ (1/3 x 1.0)

• Forthinly traded stocks and non-publicly traded companies,ananalystcan estimatebeta usinga4-stepprocess:(1)identify publicly traded benchmark company,(2) estimatethe betaof the benchmarkcompany, (3)unlever the benchmarkcompany’sbeta,and(4)relever the beta using the capitalstructureof the thinlytraded/nonpublic company

LOS 29.e

Eachof thevariousmethodsof estimating the requiredreturnonanequityinvestmenthas strengths and weaknesses

• The CAPMissimple butmayhave low explanatorypower

• Multifactor models havemoreexplanatorypowerbutare morecomplex and costly

• Build-up modelsaresimple andcanapplytoclosely held companies, but theytypicallyusehistorical valuesasestimatesthatmay or maynotbe relevanttothecurrentsituation

LOS 29.f

Inmakingestimatesof requiredreturninthe international setting,ananalyst should

adjustthe requiredreturn toreflect expectations forchangesinexchangerates.

When dealing with emergingmarkets,apremium should be addedtoreflect thegreater

levelof riskpresent.Twomethodsfor estimating thesizeof the risk premium:

• Thecountryspread modeluses acorresponding developed marketas abenchmarkand addsapremium for the emerging market risk The premiumcanbe estimated

by taking the difference between the yieldonbondsinthe emerging marketminusthe yield of corresponding bondsinthe developed market

• Thecountryrisk rating modelestimates an equationfor the equity riskpremiumfor developedcountriesand thenusesthe equation and inputs associated with theemerging markettoestimatethe requiredreturnfor the emerging market

LOS29.gThe weightedaveragecostof capital(WACC) isthe requiredreturnaveragedacrossallsuppliers of capital(i.e.,the debt and equityholders).The formula for WACCis:

WACC=

market value of equitymarket valueof debt

market valueof debt and equity market valueof debt and equitywhere:

rd andre=the requiredreturn ondebt and equity, respectively

The discountrateshould correspondtothetypeof cash flow being discounted: cash

flowstotheentirefirmattheWACCand thosetoequityatthe requiredreturn on

equity

Ananalystmay wishto measurethepresentvalueofreal cash flows, andareal discount

rateshouldbeusedinthatcase.Inmost cases, however,analystsdiscount nominal cash

flowswithnominaldiscountrates.

CONCEPT CHECKERS

Apositivereturnfromreturnfrom convergence of pricetointrinsicvalue wouldmostlikelyoccurif:

A expectedreturnisgreaterthan requiredreturn.

B requiredreturnisgreaterthanexpectedreturn.

C requiredreturnequals expectedreturn.

Foraparticularstock,the requiredreturn canbe determined by:

A multiplyingthe equity risk premiumtimesthe risk-freerate.

B multiplyinganappropriate betatimesthe equity risk premium and addinga

A Geometric meanof historicalreturnsonamarket index

B Arithmeticmeanof historicalreturnsonamarket index

C 1-yearforecasted market index dividendyield plus long-term earningsgrowth forecastminuslong-termgovernmentbond yield

Incomputingahistoricalestimateof the equity risk premium, withrespect to

possiblebiases,choosinganarithmetic average of equityreturnsandTreasury

billrateswouldmostlikely

A haveanindeterminateeffect because using the arithmetic average wouldtendtoincreasetheestimate,and using the Treasury billratewould tendtodecrease theestimate

B haveanindeterminateeffect because using the arithmeticaveragewouldtendtodecrease theestimate,and using theTreasurybillratewould tendtoincreasetheestimate

C bias theestimateupwards because using the arithmeticaveragewould tend

toincreasetheestimate,and using theTreasurybillratewould tendtoincreasetheestimate

C Amarket capitalization premium

Ananalyst wishestoestimateabetaforapubliccompanyanduseitto compute

aforward-looking requiredreturn.The analyst wouldmostlikely:

A delever the market beta and relever that value for thecompany

B regressthereturnsof thecompanyon returns on anequity market index and

adjustthe estimated beta forleverage

C regress thereturnsof the companyonreturnsonanequity market index andadjust the estimated beta for beta drift

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