Key concepts CFA 2018 level 2 schweser note book

PCA creates a number of synthetic factors defined as and calculated to be statistically independent of each other Par: The rate to discount multiple cash flows to get the present value

Ethics

All trade allocations to client accounts shall be made on a pro rata basis prior to or immediately following part or all of a block trade

Supervisors have a responsibility to ensure that compliance policies are clear and well developed Supervisors and managers must

document the procedures and disseminate them to staff In addition to distributing the policy and procedures manual, they have a responsibility to ensure adequate training of each new employee concerning the key policies and procedures of the firm Periodic refresher training sessions for all staff are also recommended

Generally, determining whether an individual has supervisory responsibilities depends on whether employees are subject to that individual’s control or influence In other words, does the individual have the authority, for example, to hire, fire, reward, and punish an employee

Duties to Employers: Disclosure of Additional Compensation Arrangements, CFA Institute members and candidates must not accept gifts,

benefits, compensation, or consideration that competes with, or might reasonably be expected to create a conflict of interest with, their employer’s interest unless they obtain written consent from all parties involved

Employers are not obliged to adhere to CFA code and standards - they should not develop conflicting practices Compliance Procedure: Member / Candidate must understand what makes an adequate system - make reasonable effort to close any gaps between current to adequate If violations occur, during investigation place employee on restricted activities and monitor their actions Inadequate Procedure: if member / candidate cant discharge supervisory duties due to inadequate systems - must decline role Adequate compliance procedure includes procedures for reporting violations

Record Retention: Inputs and outputs - meeting briefs - Retain for min of 7 years - Regulators may have different period

Recommended Procedure : member/candidate must archive notes - maintaining the records is the firms responsibility

Under Standard VI: Client interest > Employer Interest > Members or Candidates

Employees must make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity

or interfere with respective duties to their employer, clients, and prospective clients Members and candidates must ensure that such disclosures are prominent , are delivered in plain language, and communicate the relevant information effectively.

The relationship between the analyst and the company through a relative is so tangential that it does not create a conflict of interest necessitating disclosure

Proxy Voting: A cost–benefit analysis may show that voting all proxies may not benefit the client, so voting proxies may not be necessary in all instances Members and candidates should disclose to clients their proxy voting policies

Directed Brokerage: A client will direct a manager to use the client’s brokerage to purchase goods or services for the client, a practice that is commonly called “directed brokerage Because brokerage commission is an asset of the client and is used to benefit that client, not the manager, such a practice does not violate any duty of loyalty

Proper Usage of the CFA Marks Must be used as a subjective not as a noun - do not put periods between

The CFA logo certification mark is a certification mark, it must be used only to directly refer to an individual charterholder or group of charter holders

The only appropriate use of the CFA logo is on the business card or letterhead of each individual CFA charterholder

Research Objectivity: Best practice is for independent analysts, prior to writing their reports, to negotiate only a flat fee for their work that

is not linked to their conclusions or recommendations

Actions undertaken through social media that knowingly misrepresent investment recommendations or professional activities are

considered a violation of Standard I(C) Conflict of Interest: Best practices dictate updating disclosures when the nature of a conflict of

interest changes materially

Independence and Objectivity Travel Funding:

To avoid the appearance of compromising their independence and objectivity, best practice dictates that members and candidates always use commercial transportation at their expense or at the expense of their firm Should commercial transportation be unavailable, modestly arranged travel to participate in appropriate information-gathering events, such as a property tour are ok

Best practice dictates that members and candidates reject any offer of gift or entertainment that could be expected to threaten their independence and objectivity

Solicitations do not have to benefit members and candidates personally to conflict with Standard I(B) Requesting contributions to a favourite charity or political organization may also be perceived as an attempt to influence the decision-making process

If a firm claims compliance with the CFA Institute Code of Ethics and Standards of Professional Conduct, This claim has to be verified by CFA Institute A company should not discriminate among analysts in the provision of information or “blackball” particular analysts who have given negative reports on the company in the past

Issue Press Releases

Companies should consider issuing press releases prior to analyst meetings and conference calls and scripting those meetings and calls to decrease the chance that further information will be disclosed If material non-public information is disclosed for the first time in an analyst meeting or call, the company should promptly issue a press release or otherwise make the information publicly available

Prevention of Personnel Overlap

When an analyst assist the investment banking side with a project, he will be treated as an investment banker until the project is over and all non-public information is disclosed to the public - hence not allowed to use information gained for any research purposes Having analysts work with investment bankers is appropriate only when the conflicts are adequately and effectively managed and disclosed

Proprietary Trading Procedures

The most prudent course for firms is to suspend arbitrage activity when a security is placed on the watch list

GIPS: When a firm claims compliance with the GIPS standards, it must also comply with the GIPS Guidance Statement on Error

Correction in relation to the error

When claiming compliance with the GIPS standards, firms must meet all of the requirements, make mandatory disclosures, and meet any other requirements that apply to that firm’s specific situation

Agent Options: Disclose amount and time until expiration

CFA Institute recommends that firms work to achieve the following objectives when designing policies and procedures to implement the CFA Institute-ROS:

1.To prepare research reports, make investment recommendations, and take investment actions; and develop policies, procedures, and disclosures that always place the interests of investing clients before their employees’ or the firm’s interests

2 To facilitate full, fair, meaningful, and specific disclosures of potential and actual conflicts of interest of the firm or its employees

to its current and prospective clients

3 To promote the creation and maintenance of effective policies and procedures that would minimize and manage conflicts of interest that may jeopardize the independence and objectivity of research

4 To support self-regulation through voluntary industry development of, and adherence to, specific, measurable, and demonstrable standards that promote and reward independent and objective research

5 To provide a work environment for all investment professionals that supports, encourages, and rewards ethical behavior and supports CFA Institute members, CFA charterholders, and CFA candidates in their adherence to the CFA Institute Code and Standards

Covered employee: Firm employee who 1) conducts research, writes research reports, and/or makes investment recommendations;

or assists in the research process; 2) takes investment action on behalf of clients or the firm, or who comes in contact with investment recommendations or decisions during the decision-making process; or 3) may benefit, personally or professionally, from influencing research reports or recommendations

Immediate family: Individual(s) whose principal residence is the same as the principal residence of the subject person

Quiet period: Period during which covered employees are prohibited from issuing research reports or recommendations on, and

publicly speaking about, a specific subject company

Restricted period: A period of time during which a firm prohibits its covered employees from trading specified securities

Fixed income

Term Structure and Interest Rate Dynamics:

Forward Rates:

T* = When loan is initiated

T = Tenor of the loan

Forward rate = (when loan is initiated, tenor of loan)

= ( time until initiation + tenor) / ( tenor of loan )

The forward rate (Breakeven Rate):

The N square root = the tenor of the loan

The Forward price from a forward rate:

Forward Price:

T* = Period when loan is initiated = this is a discount factor now

T = Tenor of the loan = (this is a discount factor now) = (1/1+r)

Following the same principles above

Bootstrapping:

100 = (coupon / 1+spot1) + (Par and coupon / 1+ spot2 ^2 ) Spot1 = Par1 hence It is given

Spot2 = [Par + coupon / (1 – coupon/1+spot1)] - 1

Then take nth square root which 2 In this case

Once identified repeat steps to find spot etc…

The coupons will differ as the bonds on the par curve will differ

The level movement refers to an upward or downward shift in the yield curve

The steepness movement refers to a non-parallel shift in the yield curve when either

short-term rates change more than long-short-term rates or long-short-term rates change more than short-short-term rates

The curvature movement refers to movement in 3 segments of the yield curve: the short-term and long-term segments rise while the middle-term segment falls or vice versa

Principal Component Analysis:

The method to determine the number of factors—and their economic interpretation—begins with

a measurement of the change of key rates on the yield curve, The next step is to try to discover a number of independent factors (not to exceed the number of variables—in this case, selected points along the yield curve) that can explain the observed variance/covariance matrix

PCA creates a number of synthetic factors defined as (and calculated to be) statistically

independent of each other

Par: The rate to discount multiple cash flows to get the present value of

the bond (market price) this is also the YTM for Coupon paying bonds

Spot: The rate to discount individual cash flows at given maturities – it

is the YTM for a zero coupon bond

The key that links the spot curve to the par curve is that you have to get

the same price whether you use the par curve or the spot curve

(otherwise, there would be an arbitrage opportunity) The spot curve is derived from the par curve with this relationship in mind; the process to derive the spot curve is called bootstrapping

The first observation is that the forward contract price remains unchanged as long as future spot rates evolve as predicted by today’s forward curve

f(1,2) is this example is the Breakeven Rate = the rate at which an investor would be impartial to investing for 3 years

or for 2 years starting in 1 year It’s a forward rate which we

derive from the sport rate curve

Zero Spread or Z – Spread: Constant basis point spread that would need to be added to the implied spot yield curve so that the discounted cash flows of a bond is equal to its

current market price For credit / Liquidity risk Swap Spread = (Swap Rate – On the run Gov Bond Yield) It’s added on to the Government Bond Yield – covers liquidity and credit risk

Ted Spread = (Libor – T-bill) this measures the overall credit risk of the economy (related to economic cycles) Libor–OIS spread is considered an indicator of the risk and liquidity of money market securities / Measure of counterparty risk and risk in banking system Equilibrium term structure models

One-factor or multifactor models - Assume that a single observable factor ( state variable ) drives all yield curve movements Both the Vasicek and CIR models assume a single factor, the short-term interest rate Note that because both models model require the short-term rate to follow a certain process, the estimated yield curve may not match the observed yield curve But if the parameters of the models are believed to be correct, then investors can use these models to determine mispricing

Modern Term Structure Models: (Explains how interest rates evolve) The Cox–Ingersoll–Ross Model: CIR = dr=a(b−r)dt+σ√rd

b = mean reverting level

Assumes Economy has a constant long-run interest rate that the short-term interest rate converges to over time

 Interest Rates are non-negative

 Volatility increases with level on interest rates

 Explains interest rate movements in terms of an individual’s preferences for investment and consumption as well as the risks and returns of the productive processes of the economy

 Assuming that an individual requires a term premium on the long-term rate, the model shows that the short-term rate can determine the entire term structure of interest rates and the valuation of interest rate–contingent claims

 σ√rdz = stochastic or volatility term which follows the random normal distribution for which the mean is zero, the standard deviation is 1, and the

standard deviation factor is σ√r The Vasicek Model: dr = a(b – r)dt + σdz Also captures mean reversion

 Interest rates are calculated assuming that volatility remains constant

over the period of analysis Interest Rates can be negative

 The stochastic or volatility term, σdz follows the random normal distribution

for which the mean is zero & the standard deviation is 1

σdz = volatility term



Arbitrage-free models, the analysis begins with the observed market prices An

assumed random process with a drift term and volatility factor is used for the generation

of the yield curve

This calibration is typically performed via a binomial lattice-based model in which at

each node the yield curve can move up or down with equal probability This probability is

called the “implied risk-neutral or “risk-neutral probability Similar to Black-Scholes Model

Term Structure Model: Explain the shape of the curve at a point in time

 Unbiased expectations theory - Forward rates are an unbiased predictor of future spot rates Also known as the pure expectations theory

 Local expectations theory - Bond maturity does not influence returns for short term holding periods Returns for all Bonds are the same over short term

 Liquidity preference theory - Investors demand a liquidity premium that is positively related to a bond's maturity Long-term rates will be higher than investors' expectations of future rates

 Segmented markets theory - The shape of the yield curve is the result of the

interactions of supply and demand for funds in different market (i.e., maturity)

segments

o Segmented markets theory contends that asset/liability

management constraints force investors to buy securities whose maturities match the maturities of their liabilities

 Preferred habitat theory - Similar to the segmented markets theory, but recognizes that market participants will deviate from their preferred maturity habitat if compensated

Term Structure of the Interest Rate Volatility:

Short End: More linked to uncertainty about monetary policy

Long End: More linked with uncertainty about real economy and

inflation

CIR and Vsicek - both have the same drift tern but differ in terms

of stochastic terms

Arbitrage Free Valuation Framework

The first type of arbitrage opportunity is often called value additivity or, put simply, the value of the whole equals the sum of the values of the parts

Dominance Arbitrage Opportunity:

T0: T1:

Bond A 100 105

Bond B 200 220 Bond B is dominant as I can sell (2*bond) to finance 1 Bond B which will return 10% at maturity

Compare current market price vs No Arbitrage price No Arb price as PV, with coupon = PMT and F = zer0 and N = Maturity

One of the benefits of a lognormal distribution is that if interest rates get too close to zero, the absolute change in interest rates becomes smaller and smaller Negative interest rates are not possible.

Use Binomial if bonds have options

Ratchet bonds are floating-rate bonds with both issuer and investor options Ratchet bonds, in a nutshell:

 Coupon rate starts very high: much higher than the borrowing rate for the issuer

 There’s a formula for resetting the coupon rate periodically

 The rate can remain the same or decrease at a reset date; it cannot increase

 Whenever the coupon is reset lower, the bondholder has an option to put the bond at par

You can think of the reset as a sort of call option: the issuer calls the existing bond and replaces it with another callable bond that has a lower coupon rate, and the same maturity as the existing bond

Parallel shift in the yield curve will impact the effective duration of a portfolio hence portfolios with the same effective duration should have the same change in price

Binomeial Tree:

Not appropriate for MBS because it is not path dependent

Value 1L = (½) [(V2U + C) / (1 + r1L)] + [(V2L + C) / (1 + r1L)]

High Node = Middle Node x ( e N x volatility )

Low Node = Middle Node / ( e N x volatility )

N = Maturity of Bond Pathwise Valuation:

Pathwise valuation calculates the present value of a bond for each possible interest rate path and takes the average of these values across paths

Number of paths = 2 (number of cash flows – 1) Steps:

1 Specify a list of all potential paths through the tree

2 Determine present value of a bond along each potential path

3 Calculate the average PV Bond Price across all possible paths

Monte Carlo Simulation:

Used to simulate sufficinetly large number of intrest rates paths Use it when cash flows are path dependent e.g when the cash flow change depending on where the intres rates are

In MBS as interest rate drops , prepayment goes up

1.Simulate numerous paths based on probability assumption 2.Generate sport rates from the simulation

3.Determine cf for all paths and compute present value Add a constant to all spot rates at each paths so value = market value

When you have a long position in a forward or futures contract, you have, in essence, already purchased the underlying asset (you simply haven’t paid for it yet); therefore, you have positive duration If you have a short position in a forward or futures contract, you have, in essence, already sold the underlying asset (you simply haven’t been paid for it yet); therefore, you have negative duration Furthermore, the duration will be comparable to that of the underlying bonds

(Slightly different because these contracts don’t transfer ownership of the interim coupon payments, but comparable.) The same holds true for options: if you’re long calls or short puts, you have positive duration; if you’re short calls or long puts, you have negative duration Here, however, the duration will be shorter – possibly much shorter – that that of the underlying bonds; it will depend on the option’s delta

Valuation: Bonds with embedded options Convertibles

Current Market Share Price × Conversion ratio

Minimum Value of a Convertible Bond:

Conversion value or the option-free straight bond value

Market conversion price:

Current Convertible Bond Market Price / Conversion ratio

Market conversion premium per share:

Market conversion price – Current Market Share Price

Market conversion premium ratio:

Market conversion price / Underlying share price

Premium over straight Value:

Current Convertible Bond Market Price / Straight Bond Price

Soft Put:

The issuer may redeem the convertible bond for cash, common stock, subordinated notes, or a combination of the three

Callable Convertibles:

The issuer may the call option and redeem the bond early if interest rates are falling

or if its credit rating is revised upward and issue new debt at a lower cost

Busted Convertible = Call is OTM

Underlying Share Price < Conversion Share Price Bond exhibits mostly bond risk–

return characteristics Call is OTM and hence share price movements have limited

impact This is stronger when there is less time to maturity

Underlying Share Price > Conversion Share:

Bond exhibits mostly stock risk–return characteristics The call on the underlying is ITM and hence the price movements of the stock have significant impact on the bond The bond is more likely to be exercised by the bondholder

OAS:

Added to the one-period forward rates on the tree to produce a value or price for

a bond OAS = Average spreads over the Treasury spot rate curve

1 Identify the impact the change in interest rate volatility will have on

the option and Bond Price at the old and new volatility assumption

2 Assuming r is constant (1+r+OAS), compare the OAS that needs to be

added to get market price using (Bond Price / (1+ r) + OAS)

3 Market Price will be lower because it is discount by (1+r+OAS)

If two bonds have the same characteristics and credit quality, they should have the same OAS If not the bond with the largest OAS is likely to be underpriced relative to the bond with the smallest OAS

Z-Spread: = OAS - Option Cost

Option Free Bond = [Credit Spread +Liquidity Spread]

Callable Bond = [Credit Spread + Liquidity Spread] - Option Cost Putable Bond = [Credit Spread+ Liquidity Spread] - Option Cost

The Option cost for a put is negative and the option cost for a call is positive hence the OAS for all 3 will be the same It is the change in Option cost that increases or decreases the Z –spread and hence the discount rate for the Bond

Estate Puts (Death Puts):

Putable by the heirs after the death of the bondholder Bond Value hence depends

on life expectancy as well as interest rate movements

A prime example is a sinking fund bond (sinker), which requires the issuer to set

aside funds over time to retire the bond issue, thus reducing credit risk

From the issuer’s perspective, the combination of the call option and the delivery option is effectively a long straddle

As interest rates decline, the value of the straight bond rises, but the rise is partially offset by the increase in the value of the call option. Call option will be ITM because it is likely to be called by Issuer

Rate of Price Rises when Interest Rates Decline:

Straight Bond > Callable Bond > Putable Bond

Rate of Price Rises when Interest Rates Rise:

Straight Bond > Putable Bond > Callable Bond The decrease in the bond price is partially offset by the put, but net the price of the putable will decrease

Shape of Yield Curve:

Flattens/ Invents = call option is ITM and gains in value (Bond is less likely to be

option is near the money

Bond will be more sensitive to one direction of interest movement – which is the direction with the highest durations

Key rate durations (partial durations), which reflect the sensitivity of the bond’s

price to changes in specific maturities on the benchmark yield curve Thus, key rate durations help identify the “shaping risk” for bonds—that is, the bonds sensitivity to changes in the shape of the yield curve (e.g., steepening and

flattening) Can be -ve Key rate duration for a Par Bond = rate matching the tenor of the Bond

So a 10 year par bond would only be affected by 10 year key rate

Callable Bond = Bond - Call Puttable Bond = Bond + Put Callable and Puttable = Bond – Call + Put Convertible = Bond + Call

Value of floored floater = Value of straight bond + Value of embedded floor

Bondholder option Protects against rate decreases

Value of capped floater = Value of straight bond - Value of embedded cap

(Issuer option) Protects against rate increases because the coupon rate is capped

is near the exercise date

Putable bonds have more upside potential than otherwise identical callable bonds when interest rates decline In contrast, when interest rates rise, callable bonds have more upside potential than otherwise identical putable

bonds

Zero-volatility spread is a commonly used measure of relative value for MBS and ABS

Credit Analysis Models

The expected loss is equal to the probability of default multiplied by the loss given default The present value of the expected loss is the largest price to pay on a bond to a third party (e.g., an insurer) to entirely remove the credit risk of purchasing and holding the bond Uses Risk-neutral probability

The present value of the expected loss is the preferred measure because it includes the: Importance

-Risk premium in its computation

Traditional Credit Models:

Credit scoring – Ordinal:

Ranks most risky to least risky

Credit Rating- does not provide an estimate of the loan’s default probability Negative : not explicitly depend on the business cycle

Asset Backed Securities: Do no default when payment is missed

Unlike corporate debt, an ABS does not go into default when an interest payment is missed.

Structural or Reduced Form or Monte Carlo to Value

The credit risk measures used for corporate or sovereign bonds can be applied: probability of loss, expected loss, and present

value of the expected loss Probability of Default does not apply

Monte Carlo:

A constant is added to all interest rates on all paths such that the average present value for each benchmark bond equals its market value

Structural Models:

Balance sheet structure: 1 debt (zero-coupon bond) and assets

Equity owners: Equivalent to holding a long European call option on firm’s assets Debt owners: Equivalent to holding risk free bond selling European put on firm’s assets

Assumptions

 the company’s assets trade in frictionless markets that are arbitrage free,

 the riskless rate of interest, r, is constant over time ( means there is no interest rate risk)

 the time T value of the company’s assets has a lognormal distribution The probability of default depends explicitly on the company’s assumed liability structure This explicit dependency of the probability of default on the company’s liability structure is a limitation of the structural model The fact that one needs to estimate the markets equity risk premium in the computation of the company default probability is a weakness of the structural model

Negatives:

- Can’t use historical estimation – because asset prices are not observable (they do not trade)

- Balance sheet will have a liability structure much more complex than zero-coupon bond

- Interest rates are not constant over time

- The asset’s return volatility is constant , independent of changing economic conditions/ business cycles -Credit risk measures are biased because implicit estimation procedures inherit errors in the model's formulation

Reduced Form Models: Nothing is constant Reduced form models were originated to overcome a key weakness of the structural model the assumption that the

company’s assets trade

 The riskless rate of interest is stochastic

 The state of the economy can be described stochastic variables that represent the macroeconomic factors influencing the economy

 Default Probability is also stochastic The second assumption allows interest rates to be stochastic Allowing for this possibility is essential to capture the interest rate risk inherent in the pricing of fixed-income securities Only the term structure evolution must be arbitrage free

For a given state of the economy, whether a company defaults depends only on company-specific considerations, because given the macroeconomic state variables, a company's default represents idiosyncratic risk A company-specific action could be that the company’s management made an error in their debt choice in years past, which results in their defaulting now

Management error is idiosyncratic risk, not economy-wide or systematic risk The loss given default explicitly depends on the business cycle through the macroeconomic state variables This allows, for example, that in a recession the loss given default is larger than it is in a healthy economy This assumption is also very general and not restrictive

(PV expected loss > Expected Loss) = Risk Premium is dominant In other words, in the absence of a risk premium; the present value of the expected loss will be less than the expected loss

Can use Historical Estimation = Hazard rate estimation is a technique for estimating the probability of a binary event, like

default/no default More flexible than implicit estimation Using the reduced form model, the value of debt is determined by calculating the expected discounted value of debt after adjusting for risk

Value of the company’s debt = Expected discounted payoff of company debt, if there is no default

+Expected discounted payoff of debt if default occurs

Historical Estimation: one uses past time-series observations of the underlying asset’s price and standard statistical

procedures to estimate the parameters

Implicit Estimation: also called calibration, uses market prices of the options themselves to find the value of the parameter that equates the market price to the formula’s price Uses Black-Scholes model – hence no risk premium has to be estimated The problem with implicit estimation, of course, is that if one uses a misspecified model that is inconsistent with the market structure then the resulting estimates will be biased This problem can be avoided by historical estimation

Expected Loss: Notional * 1-e - default density * loss given default * N

Probability of Default: 1 – e - default density * N

Credit Default Swaps

index CDS are typically more liquid than single-name CDS

Credit Default Swaps:

The designated instrument is usually a senior unsecured obligation, which is often referred to as a senior CDS, but the reference obligation is not the only instrument covered by the CDS Any debt obligation issued by the borrower that is pari passu (ranked

equivalently in priority of claims) or higher relative to the reference obligation is covered

Succession Event:

Event that changes the debt issuer or structure of the reference entity is and their obligations

Payout ratio = (1 – Recovery rate (%) Payout amount = (pay-out ratio × Notional) (N / N of Index Entities)* Notional = Exposure to Specific Entity

If a firm in the Index defaults, remove ( Notional/ N of Index ) * Notional from Notional

Index CDS are typically more liquid than single-name CDS Cheapest to deliver = Bond trading at lowest of notional meaning where the % par value is the lowest

If bond trades 25% of par and there was another bond trading at 40% of par the 25% of par would be cheapest to deliver The maturity is not relevant in choosing the cheapest to deliver it’s the priority if claims that’s important

The hazard rate is the probability that an event will occur given that it has not already occurred Once the event occurs, there is no further likelihood of its occurrence

Probability of survival: p (%) in year 1 * p (%) in year n

Upfront payment = (PV of protection leg – PV of premium leg) Upfront premium % ≈ (Credit spread – Fixed coupon) × Duration = (100 – Price of CDS in currency per 100 Par)

Credit Spread = Upfront Payment / Duration + Fixed Coupon Price of CDS in currency per 100 par = (100 – Upfront premium % ) Profit for the buyer of protection ≈ (Change in spread in bps * Duration * Notional) Alternatively % Change in CDS price = (Change in spread in bps × Duration)

The CDS indices also permit some opportunities for a type of arbitrage trade If the cost of the index is not equivalent to

the aggregate cost of the index components, the opportunity exists to go long the cheaper instrument and short the more expensive instrument

Basis Trading: CDS is the base CDS spread > Bond Credit Spread Positive Basis = short bond (pay 1.5%) and sell CDS to profit (receive 3%) Profit = ∆ CDS spread < Bond Credit Spread

Negative Basis = long bond (receive 3%) and buy CDS (pay 1.5%) Profit = ∆ Don’t Forget: (Bond Yield – Libor) = Credit Spread of the Bond

INTERCORPORATE INVESTMENTS

`

Reclassification from HFT is severely restricted → ← Move gains & loss from OCI into IS on date of transfer

Reclassification from HFT is severely restricted → ∆ in Value (FV – Amor Cost) reported in IS

Reclassification from HFT is severely restricted ← →

← Cumulative P/L previously recognized in other OCI recognized in IS is

Previous ∆ in Value from OCI are amortised

using effective rate method in IS ← Previous ∆ in Value from OCI effective rate method in IS are amortised using

∆ in Value (FV – Amor Cost) reported in OCI → ∆ in Value (FV – Amor Cost) reported in OCI

Equity Method:

ROA and ROE are Higher because Assets and Equity (Denominator is lower )

 Liabilities and leverage = Lower

 Net Profit Margin, ROE, and ROA = Higher

 D/E is also ↓because Equity under Acquisition method includes the non-controlling stake so numerator is ↑

 Current Ratio is ↑due to lower denominato r

Allows to value at FV under Equity Method Only Allows FV for VC’s, mutual funds etc The choice of equity method or proportionate consolidation does not affect reported shareholders’ equity

Off Balance sheet financing:

SPE / SPV have to be consolidated if a firm (sponsor) has significant beneficial interest in the SPE even if no voting rights

If an SPE is reversed, on the consolidated balance sheet, the accounts receivable balance will be the same since the

sale to the SPE will be reversed upon consolidation on the balance sheet Hence consolidating an SPV reverses it

1 Has to be consolidated when total equity at risk is insufficient to finance equity without outside support

2 Equity investors lack ability to make decisions and lack obligation to absorb losses

Sponsor = party absorbing majority of losses / retains risk of default

Under IFRS, SPEs cannot be classified as qualifying

Unrecognised P/L

FV – Amortised Value (for debt)

DFV

Consolidation Process:

Non-controlling investments: Reversals are prohibited under both IFRs and US GAAP

 Tangible and Intangible Assets at FV (includes measureable and probable contingent assets and liabilities)

Acquirer Shareholder Equity Post Merger = (Capital Stock + Value of stock paid for target + Retained Earnings)

Value of stock paid for target = Portion bought + non-controlling interest

Acquisition Method Equity will be higher by the amount of the minority interest Assets and Liabilities are highest here

ROA and ROA will be different under Partial Goodwill compared to Full Goodwill This will change over time as the results of

change in equity

Differences between IFRS and U.S GAAP treatment of intercorporate investments include:

 Unrealized foreign exchange gains and losses on AFS securities are recognized on the IS under IFRS and as OCI under U.S GAAP

 IFRS permits either the partial goodwill or full goodwill method to value goodwill and non-controlling interest in

business combinations U.S GAAP requires the full goodwill method

Restructuring Cost

IFRS and US GAAP do not recognize restructuring costs that are associated with the business combination as part

of the cost of the acquisition Instead, they are recognized as an expense in the periods the restructuring costs are incurred

Among the other factors that are considered in determining whether the Group has significant influence are representation on the board of directors (supervisory board in the case of German stock corporations) and material intercompany transactions The existence of these factors could require the application of the equity method of accounting for a particular investment even though the Groups investment is for less than 20% of the voting stock

Under US GAAP, an acquirer is identified, but the business combinations are categorized as merger, acquisition, or consolidation based on the legal structure after the combination

Control is present when

1) The investor has the ability to exert influence on the financial and 2) Operating policy of the entity is exposed, or has rights, to variable returns from its involvement with the investee

Contingent Assets and Liabilities:

Both IFRS and US GAAP do not re-measure equity classified contingent consideration; instead, settlement is accounted for within equity

Under IFRS, the cost of an acquisition is allocated to the fair value of assets, liabilities, and contingent liabilities Contingent

liabilities are recorded separately as part of the cost allocation process, provided that their fair values can be measured reliably Subsequently, the contingent liability is measured at the higher of the amount initially recognized or the best estimate of the amount required to settle

Under US GAAP, contractual contingent assets and liabilities are recognized and recorded at their fair values at the time of

acquisition Non-contractual contingent assets and liabilities must also be recognized and recorded only if it is more likely than not and they meet the definition of an asset or a liability at the acquisition date Subsequently, a contingent liability is measured at the higher of the amount initially recognized or the best estimate of the amount of the loss

Contingent assets: Measured at the lower of acquisition date fair value or the best estimate of the future settlement amount Under the full method (IFRS and US GAAP), minority interest is (% x Fair Value of Target)

Under the partial method (only IFRS), minority interest is ( % x Fair Value of Net Assets)

Goodwill Impairments

IFRS: Cash generating Units Recoverable Amount < Carrying Value = Impairment Record ∆ and deduct from Goodwill Amount allocated until its zero Then reduce non-cash assets

US GAAP: Reporting Unit

1 (Fair Value < Carrying Amount) = Impairment

2 (Carrying Amount of Goodwill - Implied FV of Goodwill) = Cash Amount of Impairment

3 (Fair Value – Net Identifiable Assets) = Implied Goodwill

Fair value of reporting unit 1,300,000

Current carrying value of goodwill 300,000

= Debt can be reversed if increase in FV can be objectively related to an event occurring after the impairment loss

HTM = Reversals allowed up to original value Reclassification of equity securities under the new standards is not permitted as the initial designation ( FVPL or FVOCI) is irrevocable

US GAAP:

No Reversals for Financial Assets

Available for sale = Reversals are allowed but cannot exceed new cost basis on P/l instead any reversals beyond go into OCI The disappearance of an active market because an entity’s financial instruments are no longer publicly traded is not evidence of impairment.

Impaired Equites:

Significant changes in the technological, market, economic, and or legal environments that adversely affect the investee and indicate that the initial cost of the equity investment may not be recovered A significant or prolonged decline in the fair value of an equity investment below its cost

Business Model Test:

To be measured at amortized cost, financial assets must meet two criteria:

 A business model test: The financial assets are being held to collect contractual cash flows; and

 A cash flow characteristic test: The contractual cash flows are solely payments of principal and interest on principal

Recycling: Under AFS at sale of assets remove unrecognised P/L from OCI into Income Statement

The shareholders’ equity section of the post-acquisition consolidated balance sheet will consist of the capital stock and retained earnings account

of the parent and the non-controlling interest of the minority shareholders

Acquisition Method Goodwill: Measurement

IFRS Partial Goodwill

80% of Fair value of identifiable Net assets 720,000

IFRS and US GAAP Full Goodwill

Fair value of identifiable Net Assets 900,000

Partial Goodwill = lower Equity hence higher Debt / Full Goodwill = higher Equity hence lower Debt Bond Amortisation:

Effective Interest Rate Method:

Beginning Value of a Bond issued at Premium or Discount after N periods

PMT => Coupon

FV => Notional I/Y => Effective Rate

N => (Years to maturity at issuance – years gone by since)

PV = Bond Amortised Value at N period after issuance Equity Method Goodwill in Purchase Price when Investment in Excess of Book Value

- Ownership % * book value of target equity 66,000.00

(MV – BV) of Plant and equipment * % ownership 9,000.00

This method is used when (BV ≠ MV) and there is an excess over book value

The additional step is to amortise the value of the excess purchase price over the relevant period and exclude

it from the income that is going to the acquirer The excess will be attributable to PPE or Land most likely

Value of Investment in Associate using Equity Method * only time we use amortisation of excess

Purchase Price

+Acquirer share * Net Income

- Acquirer share * dividends paid -Amortisation of excess (because BV ≠ MV) Ending BS Value

Amortisation of coupon = (Interest Paid – Interest Income) Interest Paid = (Coupon x begin Par)

Interest Income = (Effective market rate x Cost) what we actually get

If Bond is purchased at a premium, deduct amortisation every year until it reaches par at maturity

If Bond is purchased at a discount, add amortisation every year until it reaches par at maturity

HTM Ending BS Value = Amortised Bond Value Unrealised P/L = (MV – Amortised Value) which goes into OCI

After the goodwill of the reporting unit has been eliminated, no other adjustments are made automatically to the carrying values of any of the reporting unit’s other assets or liabilities

Under both IFRS and US GAAP , the impairment loss is recorded as a separate line item in the consolidated income statement

EMPLOYEE COMPENSATION: POST-EMPLOYMENT and SHARE-BASED

Net Pension Liability = (Beginning PV of the Defined benefit obligation – Beginning FV of Plan Assets) Funded Status = (Fair value of the plan assets – PV of the Defined benefit obligation) = (Ending funded status – Employer contributions – Beginning funded status)

Periodic Pension Costs under IFRS and US GAAP

Service Cost

Income Statement

over service life

Net Interest Income or Expense

r x net pension liability / asset

Income Statement Interest expense on pension obligation Income Statement

Re-measurements

Actual Return - (r x Plan Assets)

OCI NOT Amortised

Actuarial Gains / Losses

OCI or Amortised using

corridor method to P/L

↑ or↓ Interest cost

Periodic pension costs will typically be lower because of lower opening obligation and lower service costs

Higher expected return on plan assets No effect, because fair value of return plan

assets is used on balance sheet Not applicable for IFRS

Excess = (Employer Contribution > TPPE) = financing use of funds

= equivalent to repayment of loan – use money from CFF to pay for something in CFO

↓CFF and ↑ CFO by the after tax figure

Deficit = (Employer Contribution < TPPE) = financing source of funds

= equivalent to getting a loan – hence take out money from CFO and increase CFF

↑CFF and ↓CFO by the after tax figure

After-tax $ by which the firms contribution exceeds/below total pension cost Amount = (Company Contributions - Pension Cost) * 1 – tax

Vested BO < Accumulated BO <Projected BO Stock Option Model Inputs:

Exercise Price Stock Price Volatility

Dividend Yield- high values decreases value of option = ↓compensation expense

Risk Free Rate – high value increases value of option = ↑compensation cost

Option Expense:

Expense for the year: N Options granted × (Market Price of Option / vesting period in years ) The vesting date is the date that employees can first exercise the stock options

Stock appreciation rights – employee has limited downside risk unlimited upside – no dilution

The potential for risk aversion is limited because employees have limited downside risk and unlimited upside potential

Stock Grants: Given to employees outright, with restrictions, or contingent on performance

Compensation expense is reported on the basis of the fair value of the stock on the grant date generally the market value at grant date

PBO Jan Plan Assets Jan

+Current Service Cost +Actual Return of Plan Assets +Past Service Cost +Employer Contribution +/- Plan Amendments +Employee Contribution +Interest Costs -Benefits Paid -Benefits Paid Plan Assets Dec +/-Actuarial P/L

+Employee Contribution

PBO Dec

Retroactive curtailment is a form of past service benefit for the frim hence will decrease pension cost Retroactive benefit i.e past service cost increases the pension expense

Classification of Periodic Pension Costs Recognised in P&L

To better reflect the components of periodic pension costs which can be classed as operating from non-operating items, we add the Total pension cost in P&L to operating income and deduct service cost

This adjustment: 1.Removes the amortisation of past service costs and the amortisation of net actuarial gains and losses from operating income

2 Eliminates the interest expense component and the return on plan assets component from the company’s operating income

We then add the interest expense component to interest expense on P&L and Return on Plan Assets is added into non- operating income on P&L

1 Operating Expense + ( Total Pension Expense – Service cost)

2 Deduct pension interest costs from Interest expense on P&L

3 Add return on plan assets to Interest income on P&L and deduct expected return

US GAAP:

If the plan has a surplus , the net pension asset is subject to a ceiling defined as the present value of available refunds and reductions in future contributions

Annual Unit of Credit:

1 Estimated final salary = Current Annual Salary * 1+ annual comp increase years of service

2 Lump sum value at retirement = final salary * benefit formula * years of service

3 Annual unit credit (benefit) per service year = (value at retirement / years of life post retirement)

4 Current service cost = PV of annual unit of credit

* final salary calculation might be bgn or end of period hence adjust ^years of service Assuming there are no prior service costs, the bgn PBO is zero * If there are prior service costs then bgn PBO = the PV of prior service costs

Multinational Operations

measured at current value (e.g., marketable securities and inventory measured at market value under the lower of cost

or market rule)

Current rate

measured at historical costs, ( inventory measured at cost under the lower of cost or market rule; property, plant &

equipment; and intangible assets )

Monetary, such as accounts payable, accrued expenses,

Retained earnings Beginning RE = (Net Income -Dividends) (translated using relevant rate) Do not translate RE number directly

Income Statement

Expenses related to assets translated at historical exchange rate, such as cost of goods sold, depreciation, and amortization

Treatment of the translation adjustment in the parent’s

IFRS:

The basic concept underlying the current rate method is that the entire investment

in a foreign entity is exposed to translation gain or loss Therefore, all assets and all liabilities must be revalued at each successive balance sheet date

net income

US GAAP:

Use Temporal method

Typically net asset BS exposure Typically net liability BS exposure

CTA = plug figure to make (Liability + Equity) = Assets Translation Gain or Loss = (NI – RE – Dividends ) using the RE from BS

Assets = (Total Liabilities + Capital Stock + RE) + CTA

Both IFRS and US GAAP require two types of disclosures related to foreign currency translation:

 The amount of exchange differences recognized in net income

 The amount of cumulative translation adjustment classified in OCI

 A reconciliation of the amount of CTA at the begin & end of the period

US GAAP:

Specifically requires disclosure of the amount of translation adjustment transferred from stockholders’ equity and included in current net income as a result of the disposal of a foreign entity.

The amount of exchange differences recognized in net income consists of foreign currency transaction gains and losses, and translation gains and losses resulting from application of the temporal method

How to determine functional Currency:

 Currency that mainly influences sales prices for goods and services

 Currency of the country whose competitive forces and regulations determine sales prices

 Currency that influences labour , material and costs

 Currency in which financing activities are generated Currency in which CFO receipts are retained

Only receivables turnover is the same under both translation methods current rate and temporal This is the only ratio presented in which there is no difference

in the type of exchange rate used to translate the items that comprise the numerator and the denominator

Companies often include disclosures about the effect of exchange rates on sales growth in the MD&A Such disclosures may also appear in other financial reports, such as company presentations to investors or earnings announcements

Evaluating Quality of Financial Reports

Warning Signs:

 Declining receivables turnover = revenues are fictitious or recorded prematurely or that the allowance for

doubtful accounts is insufficient Account Receivables growth > Revenue growth

 Declining inventory turnover = obsolescence problems that should be recognized

 Net income greater than cash provided by operations could suggest that aggressive accrual accounting policies

have shifted current expenses to later periods

 Lessor use of sales-type finance lease classification results in Lessor recognizing the gross profit at inception of

the lease and is a mechanism to overstate

Cash flow can be described as “low quality” either because the reported information properly represents genuinely bad economic performance or because the reported information misrepresents economic reality

Impairment / Restructuring: How often do they occur?

If regularly then normalise earnings by spreading the costs over the prior and current periods

Sudden increases to allowances or reserves and large accruals for losses indicate past period earnings were over stated

Sustainable Earnings:

Accruals = (NI – Operating Cash flow) this will consist of normal transactions and discretionary accruals

If NI > CFO on a consistent basis then there may an issue, compare with industry norms CFO less easily manipulated compared to Net Income

Receivables turnover ratio = Total revenue ÷ Average receivables

Days of sales outstanding (DSO) = 365/Receivables turnover ratio -> (Days it takes to collect revenue) Inventory turnover ratio = Cost of goods sold ÷ Average inventory

Days of inventory on hand (DOH) = 365/Inventory turnover ratio -> (Days it takes to sell inventory) Payables turnover ratio = Purchases ÷ Average trade payables

Number of days of payables = 365/Payables turnover ratio -> ( Days it takes to pay for purchases)

Cash conversion cycle (net operating cycle) = (DOH + DSO – N days of payables) (Liquidity Ratio) Source of Information about Risk

 Change in Auditor

 MD&A notes on Risks (exposure) and relationships that significantly impact firm

 Material events – change of management – legal disputes – change in control ( M&A ) Disclosures about pensions and post-employment benefits include information relevant to actuarial risks that could result in actual benefits differing from the reported obligations based on estimated benefits or investment risks that could result in actual assets differing from reported amounts based on estimates

Disclosures about financial instruments include information about risks, such as credit risk, liquidity risk, and market risks that arise from the company’s financial instruments and how they have been managed

M&A Issues:

The consolidated CFO will include the cash flow of the acquired company, effectively concealing the acquirer’s own cash flow problems Such an acquisition can provide a one-time boost to CFO that may or may not be sustainable

Understate Fair Value of assets to increase Goodwill since it’s not amortised, hence no associated amortisation charges Large accruals for losses (e.g., environmental or litigation-related liabilities) suggest that prior periods’ earnings may have been

overstated because of the failure to accrue losses earlier

Higher M-scores (i.e., less negative numbers) indicate an increased probability of earnings manipulation

Days of sales receivables (DSR): The value > one for DSR indicates that receivables as a percentage of sales have increased, may

be due to inappropriate revenue recognition Gross margin index (GMI): The value > 1 indicates that gross margins were higher last year; deteriorating margins could predispose companies to manipulate earnings. Last year’s gross margin / this year’s gross margin

Sales growth index (SGI): The value > one for indicates positive sales growth relative to the previous year Could be manipulate earnings to manage perceptions of continuing growth and also to obtain capital needed to support growth

DEPI: The value > one indicates that the depreciation rate was higher in the prior year; a declining depreciation rate can indicate

manipulated earning

AQI (asset quality index) = [1 – (PPEt + CAt)/TAt] / [1 – (PPEt–1 + CAt–1)/TAt–1], where PPE is property, plant, and equipment; CA

is current assets; and TA is total assets Change in the percentage of assets other than in PPE and CA could indicate excessive expenditure capitalization

Accruals = (Income before Extraordinary items – CFO / Total Assets) highest values to the model with a coefficient of 4.67

Anything higher than -1.78 indicates earnings manipulation Probability of Bankruptcy with Altman Z-Score Z-score = 1.2 (NWCap Inv /Tot Ass)

+ 1.4 (RE/ Tot Ass) + 3.3 (EBIT/ Tot Ass)

+ 6.1 (MVE /BVL) -> Leverage + 1.0 (Sales/Tot Ass)

High Z- score is better <1.8 = high probability of bankruptcy

>3 = low probability of bankruptcy

Scores in-between 1.8 < 3 are not a clear indication Earningst+1 = α + β1Cash flow + β2Accrualst + ε -> Higher coefficient (β1) cash represents more persistent earnings

High-quality earnings provide an adequate level of return on investment (r ≥ cost of capital) and are sustainable

Low-quality earnings (they can be of low quality because they do not provide an adequate level of return and/or they are not sustainable) Derived from non-recurring, one-off activities In addition, the term “low-quality earnings” can be used when the reported information does not provide a useful indication of the company’s performance

Remember that even GAAP-compliant financial reports can diverge from economic reality if GAAP allows for biased choices

Aggressive, premature and fictitious revenue recognition = ↑Revenue =↑ Equity =↑ Assets

Expenses omission = ↓Expenses = ↑ Net Income = (↑ Assets or ↓ Liabilities)

A company that consistently reports earnings that exactly meet or only narrowly beat benchmarks can raise questions about its earnings quality

Earnings Quality

Reporting Quality

Profitability

Typical steps involved in evaluating financial reporting quality include:

 An understanding of the company’s business and industry in which the company is operating;

 Comparison of the financial statements in the current period and the previous period to identify any significant differences in line items

 An evaluation of the company’s accounting policies, especially any unusual revenue and expense recognition compared with those of other companies in the same industry

 financial ratio analysis

 Examination of the statement of cash flows with particular focus on differences between net income and operating cash flows; perusal of risk disclosures ; and review of management compensation and insider transactions

Decomposition:

Removing Market Value of subsidiary Compute Market value of parent Subtract holding value of the subsidiary once translated into the parent’s currency

Removing Income:

Compute NI of parent Subtract income contributed by the subsidiary in parent currency This will be a line item if the holding is under Equity method

If the holding is consolidated i.e under acquisition method, we will subtract 100% of the income contribution from subsidiary Then subtract any minority interest which was not attributable to the 100% of income removed

Cash flow Quality:

In general, for established companies, high-quality cash flow would typically have most or all of the following characteristics

Positive OCF

OCF derived from sustainable sources OCF adequate to cover capital expenditures, dividends, and debt repayments OCF with relatively low volatility (relative to industry participants)

Classification shifting:

Shifting positive cash flow items from investing or financing to inflate operating cash flows

A shift in classification does not change the total amount of cash flow, but it can affect investors’ evaluation of a

company’s cash flows and investors’ expectations for future cash flows

Results in inflation of core or recurring earnings while keeping the total reported income same

This is used to mislead analysts into using a higher number as a basis for generating forecasts of future earnings and cash flows Result in inflated equity and firm valuation.

Measurement and timing issu es typically affect multiple financial statement elements

Classification issues typically affect categorization of a specific element in a financial statement

Capitalizing a lease (finance lease) enhances earnings quality because it’s on the BS and runs through the IS

An operating lease lowers earnings quality ; it’s an off BS item

With the accrual basis of accounting, revenues are recognized when earned and expenses are recognized when incurred – costs are allocated over assets life in the IS Faster mean reversion

With the cash basis of accounting, revenues are recognized when cash is collected and expenses are recognized when

cash is paid – cash flow and revenue may be recorded in different periods Slower mean reversion

Balance Sheet Quality:

With regard to the balance sheet, high financial reporting quality is indicated by:

 Completeness

 Unbiased measurement and clear presentation

High financial results quality (i.e strong balance sheet) is indicated by:

 An optimal amount of leverage

 Adequate liquidity and economically successful asset allocation The use of unconsolidated joint ventures or equity-method investees may reflect off-balance-sheet liabilities Firms with stakes in other firms that never go above 50% should be suspicious

Understatement of impairment charges for inventory; plant, property, and equipment; or other assets not only results in overstated profits on the income statement but also results in overstatement of the assets on the balance sheet

Asset impairments are write-downs of assets required when circumstances indicate that the carrying amount of an asset

is excessive compared with the expected future benefits

The term “restructuring charge” is used under IFRS to indicate a sale or termination of a line of business, closure of

business locations, changes in management structure, and/or a fundamental reorganization All of these events could also give rise to the recognition of a liability (e.g., a commitment to make employee severance payments or to make a payment to settle a lease)

Should be spread over several periods to avoid overstating / understating net income

Integration of Financial Statement Analysis Techniques

otso.olander@investmentresearch.fi

Accruals Ratio:

Look out concerning ratios < 1

Other ratio to look out for: (low values or decreasing trends are of concern) Negative Return shows inefficient asset allocation

Cash flow to reinvestment:

Cash flow to Total Debt:

Cash flow to Interest Coverage:

EBIT / CFO or CFO / Total Assets Make sure this ratio remains >1 Non-Operating Assets:

Assets not needed to operate the business e.g assets held for long-term investment purposes, marketable securities, or investment property

Years to pay debt while remaining current reinvestment policy:

Total Debt / (CFO – Total Reinvestment Spending )

Interest Coverage Ratio Adjustment:

(EBIT + Previous Lease Rent Expense – Depreciation of lease term ) / (Interest Expense + Interest Expense of Lease) Depreciation of lease term = (PV of lease term/ N) unless more information is provided

Leverage Adjustment (Assets / Equity):

Add PV of Lease to Assets only

Liabilities are unaffected because there lease payment is much lower than the PV of lease

Adjusting Assets and Liabilities for Capital Lease

Add (PV of lease - depreciation) to Assets Add (PV of lease + interest on lease for the year - lease payment) to Liability

D/E and Debt/Capital Adjustment (Debt Ratios):

Add PV of lease to Debt -> will make all ratios worse

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔=

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂𝐶𝑎𝑝𝑒𝑥 + 𝐸𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 𝑜𝑛 𝐼𝑛𝑡𝑎𝑛𝑔𝑖𝑏𝑙𝑒 𝐴𝑠𝑠𝑒𝑡𝑠

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 =

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂

𝑆𝑇 + 𝐿𝑇 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐷𝑒𝑏𝑡 + 𝐷𝑒𝑟𝑖𝑣𝑎𝑡𝑖𝑣𝑒 𝐷𝑒𝑏𝑡

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐶𝑜𝑣𝑒𝑟𝑎𝑔𝑒=

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂𝐶𝑎𝑠ℎ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑖𝑑

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝐶𝐹𝑂𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡

(Total Assets – Cash and STI) = Operating Assets (Total Liabilities – LT Debt & Debt in CL) = Operating Liabilities (Operating Assets - Operating Liabilities) = Net Operating Assets

Seek granularity and apply disaggregation (e.g using Du Pont) to look beneath the level of information presented Granular analysis will release the sources of company’s earnings drivers

Remove any income and equity from associates that the firm does not have control for

Effect from Investment in Associates on Net Profit Margin: What is the trend here? Is the contribution to NI from associates

growing year on year? Is it having a larger impact? If so this is bad

Take into account any previou s changes in accounting rules that impacted some of the years but not the others? If so restate with

adjustments This will facilitate an accurate comparison when using Du-Pont

Balance sheet: Shareholder Equity includes minority interest because parent firm has control over the firm being consolidated Financial leverage: Does not need to be adjusted for the investment in associates, i.e we do not remove it We would need to adjust the asset removed from the capital structure with another asset – the two would cancel each other out and the leverage ratio won’t change Simply put if you did not investment in the associates you would have had cash or another asset

Has Long Term Debt been rising or falling?

If Leverage is too low the firm may be underleveraged and have capacity to take advantage of opportunity

Working capital account: Liquidity

If there is deleveraging – is it paid from cash account? Not sustainable in the long run and makes liquidity ratios worse

Liquidity ability is just as important as the liquidity i.e being able to access cash quickly

Is Goodwill unusually large or small?

What is the rate of growth in Goodwill? If too large it should be further investigated This will have been a function of acquisitions

mostly E.g High intangibles like goodwill combined with low current assets might show the company has been expanding ( growth ) through acquisitions Driving earnings by acquiring isn’t sustainable! Check CFI for large outflows which will confirm the acquisitions

Cash Conversion Cycle = days in sales + days in inventory – days in payables (liquidity measure) the lower the better Segment information Revenue, Capex vs Assets:

Identify which areas have the biggest Revenues and EBIT can calculate EBIT Margin (EBIT/Revenue)

1 Compute: Segment Capex / Total Capex

Segment Assets / Total Assets

2 Compute ratios of (% Sector Capex / % Total Assets)

If the ratio is <1 then we are giving the segment a lower capex and in the future this segment will be lower of importance

The idea is to have >1 for growing segments

3 Compare with EBIT Margin i.e high capex / total assets should equate to high EBIT margin segments – if not then company is not allocation capex properly Alternatively the firm could be growing the segment which is currently producing low margins due to high capex and costs

Consider segments of the core business e.g a shoemaker may have largest income from non-core related segment Is the firm growing

a large EBIT margin segment? If not that’s questionable

Rank (capex / total assets ) by Ebit margin – if a high Ebit margin segment has a below 1 ratio of capex / total assets its likely that the segment will become less significant

Compare (CFO before interest and taxes / Ebit) make sure ratio is >1 in order for it to be sustainable

CFO is adjusted for interest and tax i.e interest and tax are added back to the CFO figure

BS Accrual = (NOA1 – NOA0) / Average NOA By using the average we adjust for differences in size

CF Accrual = [NI end − (CFO end + CFI end)] / [Average NOA]

PV of lease x r

Aggregate Accruals = (NOAt1 – NOAt-1) = simply ∆ in NOA

RETURN CONCEPTS

Expected alpha = (Expected return – Required return) Realized alpha = (Actual holding-period return − Contemporaneous required return) Expected return = required rate of return = (Current expected risk-free return + Equity risk premium)

Geometric Risk Premium < Arithmetic Risk Premium (Arithmetic is favoured by theory of finance e.g CAPM-> which uses single period returns)

Target Price consistent with fair value = V0 * (1+ r- div yield)

Vo * r- (dividends)

Rfr = Long Term Government Bonds are preferred to Treasury Bills T – Bill is preferred for short single period returns

Historical Return Adjustment:

Positive inflation and productivity surprises = high returns = increase historical mean estimate of the equity risk premium In such cases, a forward-looking model estimate may suggest a much lower value of the equity risk premium To mitigate that concern, the analyst may adjust the historical estimate downward

Risk Premium = (↑RM – Rf) = ↑ War & Negative economic influences will bias historical equity risk premium lower Risk Premium = (↓RM –↑Rf) = ↓

An artificially low risk-free rate would bias the equity risk premium estimate upward unless the required return on equity was smaller by an equal amount The failure to incorporate the return from dividends biases the equity risk premium estimate downward Risk premiums are also generally believed to be inversely related to valuation ratios

Dividend yield on the index based on year-ahead aggregate forecasted dividends and aggregate market value

+Consensus long-term earnings growth rate -Current long-term government bond yield (Div Yield + g) - rf

Ibbotson and Chen:

Equity risk premium = {[(1+eINFL) (1+egEPS) (1+egPE) −1] + eINC] − Expected Rfr

INFL:

Differences in GDP growth rates between countries may exist but this is not an important consideration specific to estimating required rate

of return between the two countries

Calculating Required Returns:

Forward looking (ex-ante) measures are less likely to have non-stationary issues

Required Return = Expected risk-free return + β (Equity risk premium)

Adjusted beta (Blume) = (2/3) (Unadjusted beta) + (1/3) (1.0)   Beta Estimation for Thinly Traded Stocks and Non-public Companies

Un-lever: Gives me the beta of the Benchmarks Assets

Fama and French:

HML = (High P/B – Low P/B)

Use T-Bill i.e short term rate as Rf

BIRR: 5 Factors

RF ( T-Bill )

+Confidence (∆ in risky corporate bonds and government bonds)

-Time Horizon (∆ change in 20yr bonds - 30 day bills) -Inflation

+Business Cycle (∆ in business activity) +Market Timing (residual unexplained)

Risk-free rate + (Beta x Equity risk premium ) + Size Premium +/- Risk Premium

A weakness of build-up models is that they typically use historical values as estimates that may not be relevant

to current market conditions

Bond yield plus risk premium method = LTD YTM + Equity Risk Premium of firm

DDM Require Rate of Return = D1 / P + g

Only use beta if there is a similar listed stock in the industry

If D/A is given simply apply D / (1-D) to get D/E

Industry and Company Analysis

Income Statement Modelling:

In a top-down approach, analysts may consider such factors as the overall level of inflation or

industry-specific costs before making assumptions about the individual company

In a bottom-up approach analysts would start at the company level, considering such factors

as segment-level margins, historical cost growth rates, historical margin levels, or the costs of delivering specific products

Variable costs are directly linked to revenue growth, and may be best modelled as a

percentage of revenue or as projected unit volume multiplied by unit variable costs

By contrast, increases in fixed costs are not directly related to revenue - they are related to future investment in PP&E and to total capacity growth

Economies of scale, a situation in which average costs per unit of a good or service produced

fall as volume rises

Testing for Economies of Scale:

Decreasing rations of COGS / Revenue and SGA / Revenue are signs of EOS

Factors that can lead to economies of scale include:

 Higher levels of production

 Greater bargaining power with suppliers

 Lower cost of capital

 And lower per unit advertising expenses Because COGS has a direct link with sales, forecasting this item as a percentage of sales is

usually a good approach Analysts should also consider the impact of a company’s hedging strategy For example, commodity-driven companies’ gross margins almost automatically decline if input prices increase significantly because of variable costs increasing at a faster rate than revenue growth

In contrast to COGS, SG&A expenses have less of a direct relationship with the revenue of a

company They have a mixture of fixed and variable costs

Cash tax rate ≠ effective tax rate ≠ statutory tax rate

Depends on DTA and DTL and tax management of the firm

Interest income is a key component of revenue for banks and insurance companies, but it is relatively less significant to most non-financial companies

Depreciation forecasts are usually based on historical depreciation and disclosure about depreciation schedules, whereas capital expenditure forecasts depend on the analysts’

judgment of the future need for new PP&E Technological Change:

Usually leads to lower costs – if its proprietary it will sustain cost advantage

If non-proprietary it will have advantage in short run to early adopters

Balance Sheet Modelling:

Build forecast from working capital accounts and efficiency ratios

If efficiency ratios are held constant, working capital accounts will grow in line with Revenue (assuming a historical cost relationship)

Non-Current Assets: ∆NCA = (Capex – Depreciation)

Capex should be < Depreciation due to inflation

Return Measures:

ROIC = (NOPLAT / Invested Capital) = EBIT x (1 – effective tax) Invested Capital = (Operating Assets – Operating Liabilities) NOPLAT = Net Operating Profit Less Adjusted Tax ROIC is a better measure of profitability than return on equity because it is not affected by a company’s degree of financial leverage because we do not deduct any interest payments in NOPLAT In general, sustainably high ROIC is a sign of a

competitive advantage To increase ROIC, a company must either increase earnings, reduce invested capital

ROCE = (ROIC before Tax) = (Operating Profit / Capital Employed) = EBT / (Assets – Liabilities)

Useful for comparing companies in different tax jurisdiction The rational efficient markets formulation (Grossman and Stiglitz, 1980) recognizes that investors will not rationally incur the expenses of gathering information unless they expect to be rewarded by higher gross returns compared with the free alternative

of accepting the market price

In an inflationary environment, raising prices too late will result in a profit margin squeeze but acting too soon could result in volume losses In a deflationary

environment, lowering prices too soon will result in a lower gross margin but waiting too long will result in volume losses

Mature companies may be able to accelerate their long-term growth rate through product innovation and/or market expansion

Average annual growth different from CAGR Forecasting:

When forecasting e.g a 5% increase in COGS or SGA, the formula is (Current COGS/Current Sales) x 1.05 For absolute numbers like sales it simple sales x (1+g)

Upward cost pressure = supplier power and buyer power (high quality service) Downward price pressure = low entry barriers

= High buyer power

= Substitutes

= Fragmented market with intense rivalries

Operating Assets are needed to generate revenue and run the company on a day to

day basis

 Accounts receivable Income Tax Payable

Scenario Analysis and Sensitivity Analysis

Either sensitivity analysis or scenario analysis can be used to determine a range of potential intrinsic value estimates based on a variety of different assumptions about the future Analysts can use either tool to estimate the effect on a company’s valuation of different assumptions for economic growth, for inflation, for the success of a particular product, and so on

Cannibalization Inflation, Deflation and Costs

Dividend Discount Model

B = retention rate

Gordon Growth Model:

Leading / Forward PE:

Trailing PE:

Perpetuity:

PVGO:

Value = (No Growth + PV of Growth) hence PVGO = (Value – No Growth)

Companies that have good business opportunities and/or a high level of managerial flexibility in responding to changes in the marketplace should tend to have higher values of PVGO than companies that do not have such advantages

g = (b × ROE) = dividend growth rate

b = earnings retention rate (1 – Dividend Payout Ratio) ROE = return on equity

Sum-of-the-parts analysis is most useful when valuing a company with segments in different industries that have different valuation characteristics Sum-of-the-parts analysis is also frequently used to evaluate the value that might be unlocked in a restructuring through a spin-off, split-off, tracking stock, or equity (IPO) carve-out

Conglomerate discount refers to the concept that the market applies a discount to the stock of a company operating in multiple, unrelated businesses compared to the stock of companies with narrower focuses

Leverage = ROE / ROA Asset Turnover = ROA/NPM

Disproportionate returns would result when control shareholders increase their returns through above-market compensation and other actions that reduce the returns available to minority shareholders For private companies seeking a liquidity event through an IPO or strategic sale of the entity, the likelihood of actions by a control group that reduce the earnings of an entity is reduce

Multi Stage:

The H-Model with linear growth: No need to discount final figure!

When to use H-Model

A firm that has little competition now, but has competition that is expected to increase, is a candidate for the H-model Growth can be expected to decline as competitors enter the market Growth then stabilizes as the industry matures

Du-Pont:

PRAT:

Growth is a function of profit margin (P) , retention rate (RR) , asset turnover (A) , and financial leverage (T)

g can be decomposed in a variety of ways:

ROE = Return on assets × Leverage = first part of Du-Pont

g = Net profit margin × Asset turnover × Leverage = 3 factor Du-Pont

g = EBIT margin × Tax burden × Interest burden × Asset turnover × Leverage = 5 factor Du-Pont

H - Model r:

r = Dividend Yield x (1+gl + H adjustment) + gl

Sustainable Growth Rate:

The sustainable growth rate model assumes that the growth will be financed with issuance of debt and internally generated equity

When to use 2 Stage

A firm that is expected to have a high rate of growth until patents expire, for example, should be modelled by the two-stage model, with one rate of growth before the patent expires and another rate thereafter

Use Dividends Not Earnings

Free Cash Flow Valuation

Use when Investor has a control perspective Conceptually FCFE = (Operating Assets + Marketable Securities + Cash ) – MVD

FCInv = Net purchase of fixed assets = Increase in gross fixed assets i.e includes Deprecation! (The y-o-y change)

This can also be net purchase of property, plant, and equipment from CFI FCInv = change in net fixed assets + depreciation expense

= change in GROSS PPE

Net Debt: (New debt issuance – Principal repayments) = ∆ in debt outstanding

FCFF = CFO + Interest (1-tax rate) - FCInv

FCFE = CFO − FCInv + Net borrowing CFO incorporates adjustments for noncash expenses (such as depreciation and amortization i.e they were never deducted because they are not a cash expense) as well as for net investments in working capital

Deferred Taxes:

Generally, if the analyst’s purpose is forecasting and, therefore, identifying the persistent components of FCFF, then the analyst should not add back deferred tax changes that are expected to reverse in the near future

If a company is growing and has the ability to indefinitely defer its tax liability, adding back deferred taxes to net income

is warranted – i.e they will not reverse FCFE = FCFF – Int(1 – Tax rate) + Net borrowing

Transactions between the company and its shareholders (through cash dividends, share repurchases, and share issuances)

do not affect free cash flow Leverage changes, such as the use of more debt financing, have some impact because they increase the interest tax shield ( reduce corporate taxes because of the tax deductibility of interest) and reduce the cash flow available to equity In the

long run, the investing and financing decisions made today will affect future cash flows

(FCInv > NCC): Due to inflation FCInv should be larger; if it isn’t then we have just about enough FCInv to support and

maintain current growth

(FCInv <NCC): This is not sustainable

FCFF = EBIT (1 – Tax rate) + Dep – FCInv – WCInv ( add NB for FCFE) FCFF = EBITDA (1 – Tax rate) + Dep (Tax rate) – FCInv – WCInv ( add NB for FCFE) Net Income = (EBITDA – Dep – Int) * (1 – Tax rate)

In the calculation of net income, many noncash charges are made after computing EBIT or EBITDA, so they do not need to be added back when calculating FCFF based on EBIT or EBITDA

In general, a firm has the following alternative uses of positive FCFF:

1) Retain the cash and thus increase the firm’s balances of cash and marketable securities;

2) Use the cash for payments to providers of debt capital ( i.e., interest payments and principal payments in excess of new borrowings )

3) Use the cash for payments to providers of equity capital (i.e., dividend payments and/or share repurchases in excess of new share issuances )

Similarly, a firm has the following general alternatives for covering negative free cash flows:

o Draw down cash balances

o Borrow additional cash

o Issue equity

Forecasting FCFF and FCFE:

FCInv – Dep represents the incremental fixed capital expenditure net of depreciation By assuming a target DR, we eliminated the need to forecast net borrowing Net borrowing = DR*(FCInv – Dep) + DR*(WCInv)

By using this expression, we do not need to forecast debt issuance and repayment on an annual basis to estimate net borrowing

This will not work if the firm has significant NCC other than depreciation.

FCFE = NI – (1 – DR ) (FCInv – Dep) – ( 1 – DR ) (WCInv)

= NI − ( 1−DR ) (Net investment in operating assets)

FCFF: Can also be used for FCFE by starting with NI

Investment in fixed capital in excess of depreciation (FCInv – Dep) and investment in working capital (WCInv) both bear a constant relationship to forecast increases in the size of the company as measured by increases in sales.

Free Cash Flow Tied to Sales EBIT (1 − Tax rate) - Incremental FC - Incremental WC Incremental FC = (Capex – Dep Expense) / Increase in Sales * Increase in Sales Incremental WC = Increase in WC / Increase in Sales * Increase in Sales Alternatively its: NI – Incremental FCInv – Incremental WCInv + NB Net borrowing = (Increase in notes payable + Increase in long-term debt)

When excluding NB from FCFE to get FCFF this figure can be –ve Hence it will be added

Total net payment to equity holders = (Net change in cash – FCFE) Notes payable represents a short term debt obligation and hence an increase in notes payable would result in an increase in net borrowings all things being equal

If the company has preferred stock, the FCFE equation is essentially the same Net borrowing in this case is the total of new

debt borrowing and net issuances of new preferred stock

λ

EBITDA is a poor measure of the cash flow available to the company’s investors because it does not capture depreciation tax shield and the differences in FC and WC Even poorer measure for FCFE due to not capturing after tax interest costs or new borrowing

Share repurchase and cash dividends on common stock does not affect FCFF or FCFE, which are the amounts of cash available

to all investors or to common stockholders Change in Leverage impacts FCFE

In the year the debt is issued, it increases the FCFE by the amount of debt issued After the debt is issued, FCFE is then reduced

by the after-tax interest expense

To capture preferred stock dividends we add the preferred dividends back to NI

Equity Value = Firm Value – MVD – MV of Preferred Debt

Interest Expense / MVD = Cost of capital International Application of Require Rate of Return = does not include inflation

Country Return ( real ) +Industry Adjustment +Size Adjustment +Leverage Adjustment This approach is particularly useful for countries with high or variable inflation rates

2 Stage FCFF and FCFE

Same principle of multi stage

CFO = NI + Depreciation + (Cash from Equipment Sale – Cash outflow Equipment Bought)

As depreciation increases Ni decreases and CFO increases

Value of firm = Value of operating assets + Value of non-operating assets

If a company has significant non-operating assets, such as excess cash, excess marketable securities, or land held for investment, then analysts often calculate the value of the firm as the value of its operating assets (e.g., as estimated by FCFF valuation) plus the value of its non-operating assets:

Free cash flow valuation focuses on the value of assets that generate income or are needed to generate operating cash flows

In general, if any company asset is excluded from the set of assets being considered in projecting a company’s future cash flows, the analyst should add that omitted asset’s estimated value to the cash-flows-based value estimate

Some companies have substantial noncurrent investments in stocks and bonds that are not operating subsidiaries but, rather, financial investments These investments should be reflected at their current market value Those securities reported at book values on the basis of accounting conventions should be revalued to market values

The two-stage model is best suited to analysing firms in a high growth phase that will maintain that growth for a specific period, such as firms with patents or firms in an industry with significant barriers to entry

4 Factor Model

Application and Processes:

Any departure of market price from the manager’s estimate of intrinsic value is a perceived mispricing

Mispricing = (Intrinsic Value – Market Price) + ( estimated Intrinsic Value – Market Price)

The Valuation Process:

1 Understanding the business Industry and competitive analysis, together with an analysis of financial statements

and other company disclosures, provides a basis for forecasting company performance

a Cost leadership : being the lowest cost producer while offering products comparable to those of other companies, so that products can be priced at or near the industry average;

b Differentiation: offering unique products or services along some dimensions that are widely valued by buyers so that the company can command premium prices; and

c Focus : seeking a competitive advantage within a target segment or segments of the industry, based on either cost leadership (cost focus) or differentiation (differentiation focus)

2 Forecasting company performance Forecasts of sales, earnings, dividends, and financial position (pro forma

analysis) provide the inputs for most valuation models

3 Selecting the appropriate valuation model Depending on the characteristics of the company and the context of

valuation, some valuation models may be more appropriate than others

4 Converting forecasts to a valuation Beyond mechanically obtaining the “output” of valuation models,

estimating value involves judgment

5 Applying the valuation conclusions Depending on the purpose, an analyst may use the valuation conclusions to

make an investment recommendation about a particular stock, provide an opinion about the price of a transaction,

or evaluate the economic merits of a potential strategic investment

In summary, an effective research report:

 contains timely information

 is written in clear, incisive language

 is objective and well researched, with key assumptions clearly identified

 distinguishes clearly between facts and opinions

 contains analysis, forecasts, valuation, and a recommendation that are internally consistent;

 presents sufficient information to allow a reader to critique the valuation

 states the key risk factors involved in an investment in the company; and

 discloses any potential conflicts of interests faced by the analyst

Market Based Valuations: Price and Enterprise Multiples

Comparable (Relative Valuation): Compare vs Benchmark or Peer group PE Leading PE > Actual PE = Overvalued

Usually the leading PE is smaller than the training PE because Earnings are grown by G in the trailing PE Justified PE is not based market price – instead it’s based on the prices which are justified by current fundamental information

E.g price calculated from FCFE or based on peer group justified P/B or P/E Based on intrinsic value of price instead of actual price

Compare (Benchmark PE * Target EPS) vs (Current Market Price) or Target PE vs Benchmark PE on its own

Look at historical relationship between (Intrinsic Value & Market Value) or (Target PE vs BM PE)

Have there been changes? If so adjust PE could have been 80% of BM historically, in that case compare Target PE vs ( 80% * BM PE )

If not can the differences be explained by differences in fundamentals e.g asset turnover / profitability or risks (liquidity, leverage)?

A firm with higher growth rates should have higher PE or a firm with higher leverage should have lower PE

Transitory firm components are expected to be non- recurring and are excluded to calculate core EPS Analyse carefully

Use forward looking PE when investment is forward looking or when there have been lots of unusual items distort past earnings.

A predicted P/E, which is conceptually similar to a justified P/E, can be estimated from cross-sectional regressions of P/E on the

fundamentals believed to drive security valuation:

PE +ve DPR –ve Beta +ve Growth

↑P/Es on depressed EPS at the bottom of the cycle and low P/E’s on unusually ↑EPS at the top of the cycle reflect the countercyclical property of P/E’s known as the Molodovsky Effect In this case ↑PE = undervalued due to Molodovsky effect

NTM PE = Price / [t/12 x total year EPS] + [12-t / 12 *Next year’s EPS]

Fiscal Year EPS = Subject to firms fiscal year Current Fiscal Year EPS = only use EPS for quarters in current fiscal year

Next 4 Quarters EPS = Can include both current and next fiscal year EPS

Normalized EPS: Calculated as average EPS over the most recent full cycle may not be reflective of current size of the firm due to information being old

Average RO E: Calculated as the average return on equity (ROE) from the most recent full cycle, multiplied by current book value per share Average ROE x Current BVPS = Normalised EPS

For stocks with comparable relative valuations, the stock with the greatest expected growth rate (or the lowest risk) is, all else equal, the most attractively valued

Fundamental Factor Explanation Beta

Wacc

P/E is a decreasing function of risk ↑Beta = ↓ P/E Same as above

g P/E is an increasing function of the growth rate of the company—that is, the higher the expected

growth, the higher the P/E

Equity risk premium P/E is a the required return, which lowers the price of a stock relative to its earnings decreasing function of the equity risk premium An increased equity risk premium increases

Potential drawbacks to using P/Es derive from the characteristics of EPS:

 EPS can be zero, negative, or insignificantly small relative to price, and P/E does not make economic sense with a zero, negative, or insignificantly small denominator

 The ongoing or recurring components of earnings that are most important in determining intrinsic value can

be practically difficult to distinguish from transient components

 The application of accounting standards requires corporate managers to choose among acceptable alternatives and to use estimates in reporting In making such choices and estimates, managers may distort EPS as an accurate reflection of economic performance Such distortions may affect the comparability of P/Es among companies

The Fed Model:

Based on the premise that the two yields should be closely linked, on average, the trading rule based on the Fed Model

considers the stock market to be overvalued when the market’s current earnings yield is less than the 10-year Treasury bond (T-bond) yield The intuition is that when risk-free T-bonds offer a yield that is higher than stocks—which are a riskier investment—stocks are an unattractive investment

Another drawback to the Fed Model is that the relationship between interest rates and earnings yields is not a linear one.

Critics of the Fed Model point out that it ignores the equity risk premium and inadequately reflects inflation

The Yardeni Model: Gives a justified P/E (Think of it as 1 / r – g) where (1/ CBY – b x LTEG)

CEY = CBY – b × LTEG + Residual CBY is the current Moody’s Investors Service A-rated corporate bond yield LTEG is the consensus five-year earnings growth rate forecast for the market index

Does not incorporate an equity risk premium per se Consistent with valuation theory, in Yardeni’s model, ↑current corporate bond yields imply a ↓justified P/E and ↑expected long-term growth results in a ↑justified P/E

P/E and Inflation - For two companies with the same pass-through ability, the company operating in the environment

with higher inflation will have a lower justified P/E ; if the inflation rates are equal but pass-through rates differ, the justified P/E should be lower for the company with the lower pass-through rate

With less than 100 % cost through, the justified P/E is inversely related to the inflation rate (with complete cost through, the justified P/E should not be affected by inflation)

pass-↑Inflation =↓PE hence ∆ in PE may be justified by ∆in inflation rates or ∆in pass-through rates

P = real rate of required return = r – I λ= % of inflation costs that can be passed on

I = Inflation

PE = 1/ real r + (1- λ) x Inflation

P/B: Market Cap / Equity High P/B is justified by

↓r

↑ROE

↑growth

This is a re-arranged version of 1 + [(ROE − r ) x B0) / (r − g)] to get a Justified P/B

Possible drawbacks of P/Bs in practice include the following:

 Accounting effects on book value may compromise how useful book value is as a measure of the shareholders’

investment in the company

 Intangible Assets e.g human capital may not be reflected on the BS and hence Book Value

 Share repurchases or issuances may distort historical comparisons

 For assets measured at net historical cost, inflation and technological change can eventually result in significant divergence between the book value and the market value of assets

Residual Income Model:

P/S: Usually reported on the basis on trailing sales –> the 1+g for the justified P/S P/S is calculated as price per share divided by annual net sales per share (net sales is total sales minus returns and customer discounts

Justified P/S:

Share price reflects the effect of debt financing on profitability and risk In the P/S multiple, however, price is compared with sales, which is a pre-financing income measure—a logical mismatch Use a ratio of enterprise value to sales because enterprise value incorporates the value of debt

P/S does not reflect differences in cost structures among different companies and Sales are stable and of particular value when dealing with cyclical companies.

The fact that (Sales) × (Net profit margin) = Net income means that (P/E) × (Net profit margin) = P/S

NPM = (P/S ÷ P/E) hence P/S is an increasing function of NPM and earnings growth rate

High P/S is justified by ↑NPM, ↑g, ↑ROE and ↓r

P/CF = CF (defined as EPS plus per-share depreciation, amortization, and depletion) The difference between TIC and EV is that EV excludes cash, cash equivalents, and marketable securities For purpose of calculating TIC/EBITDA or EV/EBITDA

Compare the dividend yield in combination with r and g

Does the firm have positive growth and is it paying a sustainable dividend pay-out ratio? i,e below 100%?

Also compare the total return (div yield + capital appreciation) with the dividend yield

Dividend Yield = D0/P0 = r-g/1+g

Enterprise Value Multiples

Typically a pre-interest income measure - Enterprise value multiples are relatively less sensitive to the effects of financial leverage than price multiples when one is comparing companies that use differing amounts of leverage

EV/EBITDA is usually more appropriate than P/E alone for comparing companies with different financial leverage (debt), because

EBITDA is a pre-interest earnings figure, in contrast to EPS, which is post interest

High EBITDA is justified by

↑g

↑ROIC

↓wacc (because it’s firm wide)

EV = (MVE + MV Preferred Stock + MVD + MV Non-Control) – (Cash Equivalent & Short-term Investments) Equity = (EV + Cash Equivalent, Short-term Investments ) - MVD

Cash and Equivalent are subtracted because EV is designed to measure the net price an acquirer would pay for the company as a whole The acquirer must buy out current equity and debt providers but then receives access to the cash and investments, which lower the net cost of the acquisition

ROIC is the relevant measure of profitability because EBITDA flows to all providers of capital

EBITA Use when amortization related in intangibles is a major expense for companies being compared

EBIT may be chosen where neither depreciation nor amortization is a major item

Cross Border Valuations:

Pay attention to Accounting methods, tax regimes, and cultural differences

International considerations:

P/CFO and P/FCFE will generally be least affected by accounting differences

P/B, P/E, and multiples based on such concepts as EBITDA, which start from accounting earnings, will generally be the most affected

Scaled earnings surprise = Surprise / σ of analyst earnings forecast – scaled by analyst forecast

Standardized Unexpected Earnings: Scaled by the standard deviation in past unexpected earnings

EPSt = actual EPS for time t E(EPSt) = expected EPS for time t σ[EPSt – E(EPSt)] = standard deviation of [EPSt – E(EPSt)] over some historical time period Relative-strength indicators allow comparison of a stock’s performance during a period either with its own past performance (first type) or with the performance of some group of stocks (second type)

The rationale for using relative strength is the thesis that patterns of persistence or reversal in returns exist

Screening is the application of a set of criteria to reduce an investment universe to a smaller set of investments and is a part of

many stock selection disciplines In general, limitations of such screens include the lack of control in vendor-provided data of the calculation of important inputs and the absence of qualitative factors

If we are evaluating two stocks with the same P/B, the one with the↑ ROE is relatively undervalued

Harmonic Mean:

The harmonic mean is sometimes used to reduce the impact of large outlier s —which are typically the major concern in using the arithmetic mean multiple— but not the impact of small outliers (i.e., those close to zero)

Harmonic mean

Weighted harmonic mean – most accurate - Avoids outliers

The two best methods are to take median and weighted harmonic mean to calculate industry averages

Harmonic < Arithmetic

Possible drawbacks of using P/S in practice include the following:

 A business may show high growth in sales even when it is not operating profitably as judged by earnings and cash flow from operations To have value as a going concern, a business must ultimately generate earnings and cash

 Share price reflects the effect of debt financing on profitability and risk In the P/S multiple, however, price is compared with sales, which is a pre-financing income measure—a logical mismatch

 P/S does not reflect differences in cost structures among different companies

 Although P/S is relatively robust with respect to manipulation, revenue recognition practices have the potential to distort P/S

Possible drawbacks to using EV/EBITDA include the following: *Worst account discrepancies *

 EBITDA will overestimate CFO if working capital is growing

 EBITDA also ignores the effects of differences in revenue recognition policy on cash flow from operations

 Free cash flow to the firm ( FCFF ), which directly reflects the amount of the company’s required capital expenditures, has a stronger link to valuation theory than does EBITDA Only if depreciation expenses match capital expenditures

do we expect EBITDA to reflect differences in businesses’ capital programs This qualification to EBITDA comparisons may be particularly meaningful for the capital-intensive businesses to which EV/EBITDA is often applied

 EPS plus per-share depreciation, amortization, and depletion (CF)

o Limitation : Ignores changes in working capital and noncash revenue; not a free cash flow concept

 Cash flow from operations (CFO)

o Limitation : Not a free cash flow concept, so not directly linked to theory

 Free cash flow to equity (FCFE)

o Limitation : Often more variable and more frequently negative than other cash flow concepts

 Earnings before interest, taxes, depreciation, and amortization (EBITDA)

o Limitation : Ignores changes in working capital and noncash revenue; not a free cash flow concept Relative to its use in P/EBITDA, EBITDA is mismatched with the numerator because it is a pre-interest concept

Residual Income

Economic Profit = Economic Value Added = NOPAT – (WACC % × Total Capital) Residual Income

RI = (ROE –r)* BVo

RI = (NI – Equity Charge)

RI = (NI+OCI) – Equity Charge

Stock Value using Residual Income = (Book value per share) + (Present value of expected future per-share residual income)

RE + Common Stock = Equity BV0 + PV 0f (Earnings – r x BV0) BV0 + PV of (Residual Income for each individual Period) BV0 + PV of [ROE – r x (BV0) / r-g ] = Single Stage RI

BV0 + PV of RI + (PV of Perpetuity of Sustainable RI )

EPS = B Dividend = C Equity Charge = (Cost of Equity) x A Ending Book Value = A+ (B - C)

Residual Income = (B - Equity Charge)

Adjustments:

Deferred taxes are eliminated such that only cash taxes are treated as an expense Any inventory LIFO reserve is added back to capital

Increase in the LIFO reserve is added in when calculating NOPAT

Because of the adjustments made in calculating EVA, a different numerical result will be zero 

Market Value Added = (MVD + MVE) – (Accounting Value of Firm)

A company that generates positive economic profit should have a market value in excess of the accounting book value of its capital

PV of Economic Profit = (Share Price – BVPS ) = the relationship that a firm with positive economic profit should have a market value in excess of the accounting book value of its capital

Multistage Residual Income Model:

Premium over BV = Price at ending period – BV at current period

BV0 + PV 0f (Earnings – r x BV0) + ( PV of Premium over BV) BV0 + PV of [ROE – r x (BV0)] + ( PV of Premium over BV)

Using a Persistent Factor:

A persistence factor of one implies that residual income will not fade at all; rather it will continue at the same level indefinitely (i.e., in perpetuity)

A persistence factor of zero implies that residual income will not continue after the initial forecast

horizon

In practice, because the RI model uses primarily accounting data as inputs, the model can be sensitive to accounting choices, and aggressive accounting methods ( e.g., accelerating revenues or deferring expenses ) can result in valuation errors Aggressive accounting =↑ book value

Violations of the Clean Surplus Relationship: Violations of this assumption occur when accounting

standards permit charges directly to stockholders’ equity, bypassing the income statement e.g CTA, P/L

from hedging instrument, unrealised changes in FV instruments

When OCI is not included to arrive at Net Income, growth rate in residual income is generally not equal to the growth rate of net income or dividends

How to adjust for OCI in RI when there is a clean surplus violation

BVt0 + NI +E – Div – OCI = BVt1 R&D expenditures are reflected in a company’s ROE, and hence residual income, over the long term

Productive R&D will increase ROE and RI Simply put ROE should reflect the productivity of R&D expenditures without requiring an adjustment

Expensing R&D = ↓ROE immediately but ↑ROE in future years when the capitalised expenditure is

amortised Hence Capitalising R&D = ↑ROE Intangible assets can have a significant effect on book value In the case of specifically identifiable

intangibles that can be separated from the entity (e.g., sold), it is generally appropriate to include these in the determination of book value of equity If these assets have a finite useful life, they will be amortized over time as an expense Intangible assets, however, require special consideration because they are often not recognized as an asset unless they are obtained in an acquisition

(T-1) because it is the PV of

the Terminal Value

The strengths of residual income models include the following:

 Terminal values do not make up a large portion of the total present value, relative to other models

 RI models use readily available accounting data

 The models can be readily applied to companies that do not pay dividends or to companies that do not have positive expected near-term free cash flows

 The models can be used when cash flows are unpredictable

 The models have an appealing focus on economic profitability

The potential weaknesses of residual income models include the following:

 The models are based on accounting data that can be subject to manipulation by management

 Accounting data used as inputs may require significant adjustments

 The models require that the clean surplus relation holds, or that the analyst makes appropriate adjustments when the clean surplus relation does not hold

 The residual income model’s use of accounting income assumes that the cost of debt capital is reflected appropriately by interest expense

Private Firm Valuation

Income Approach Methods:

Required Return:

Expanded CAPM = CAPM r + size premium and firm specific risk adjustments Build up model =Rf + (Beta x Equity risk premium) +Industry Risk Premium + firm specific risk adjustment

Capitalized Cash Flow Method (CCM): Similar to single stage DDM with constant g Preferred model

Appropriate, for valuing a private company in which no projections are available and an expectation of stable future operations

exists Excess Earnings Method: Estimates the earnings remaining after deducting amounts that reflect the required returns to working

capital and fixed assets (i.e., the tangible assets) - Residual is then capitalised using CCM – Rarely used Good for valuing intangible assets and very small businesses when other such market approach methods are not feasible

Residual Earnings = Normalised Earnings – (r * WCInv) – (r * FCInv) Intangible Assets Value = (Residual Earnings * 1+g ) / (r -g)

Excess Earnings = (WCInv) + (FCInv) + (Intangible Assets) similar to Residual Income approach EEM is only rarely used in pricing entire private businesses, and then only small ones.

Small size typically increases risk levels, and risk premiums for small size have often been applied in estimating required rates of

return for private companies For some private companies, small size may reduce growth prospects by reducing access to capital

to fund growth of operations

Tax concerns Reduction of reported taxable income and corporate tax payments may be a more important goal for private

companies compared with public companies because of greater benefit to the owners Generally, stock-specific factors are a negative for private company valuation whereas company-specific factors are potentially positive or negative

Market Approach:

Guideline Public Company Method (GPCM): Value estimate based on the observed multiples from trading activity in the shares

of public companies viewed as reasonably comparable to the subject private company

1 Find a public listed firm which is comparable and use its multiple e.g MVIC/EBITDA adjusted for risk and growth characteristics to value private firm E.g if MVIC/EBITDA was 8 and we would adjust 8 upward or downward

2 Apply multiple to find firm value and adjust for control premium, exclude debt if we are looking for equity value only

No further adjustment needed unless there is a strategic buyer

 A strategic transaction involves a buyer that would benefit from certain synergies associated with owning the target firm

 A financial transaction involves a buyer having essentially no material synergies with the target

 Pricing multiples from GPCM typically reflect public trading in small blocks of stock The multiples may not reflect the value of the total equity of the public companies

Factors to consider:

Multiple might be artificially high due to recent M&A transactions or other industry trends may impact the multiple

The Guideline Transactions Method (GTM): There is no need to adjust for control premium because multiples are based on

acquisitions of public or private companies

 Contingent consideration re presents potential future payments to the seller that are contingent on the achievement of certain agreed on occurrences

 Meaningful data may be limited due to lack of transactions

 Changes in the marketplace since transaction occurred could result in differing risk and growth expectations requiring an adjustment to the pricing multiple Bad Thing

 The guideline transactions method considers market transactions involving the acquisition of the total equity of companies As such, the pricing multiple more accurately reflects the value of total companies Good thing

The Prior Transaction Method (PTM): considers actual transactions in the stock of the subject company

If available, timely, and arm’s length, the PTM would be expected to provide the most meaningful evidence of value

Asset-Based or Cost Approach: (weakest method ): The principle underlying the asset-based approach is that the value of ownership of an enterprise is equivalent to the fair value of its assets less the fair value of its liabilities

 Rarely used for going concern – more relevant for firms in liquidation

 Good for real estate investment trusts (REITs) and closed end investment companies (CEICs) or small businesses with limited intangible value or early stage companies

 Also useful for Banks and finance companies largely consist of loan and securities portfolios

The value of a company in liquidation reflects the assumption that the assets might be redeployed by buyers to higher valued uses This is one reason why its value as a going concern might be less than its value in liquidation

Valuations used for financial reporting do not involve mandatory compliance with USPAP or other professional standards More generally, business appraisers are typically not required by law to adhere to these standards

Fair Market Value – includes DLOM + DLOC = Hypothetical Value

Fair Value – where market price cannot be determined (No Discounts here) Market Value – Price currently observable in the markets

Investment Value – Value to a particular buyer Intrinsic Value – Value of the whole firm using FCFF with adjustments

Lack of marketability discounts are frequently applied in the valuation of non-controlling equity interests in private companies

DLOC = (Control Premium / 1+Control Premium) hence Control Premium = (1 +DLOC) x DLOC Total Discount = (DLOC + DLOM) = 1- [(1-DLOM) x (1-DLOM)]

The DLOM can be estimated using restricted share versus publicly traded share prices

Pre-IPO versus post-IPO prices Put prices

Control + Synergies = ↑ Control Premium Non - Controlling = ↑Discount for Lack of Control

The advantage of using put prices over the other two DLOM estimation methods is that the estimated risk of the firm can be

factored into the option price.

WCInv, FCInv and Intangible Assets will all have different r

Use Normalised Earnings Target’s wacc not the Acquirers

Optimal capital structure of Target rather than actual*