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LOS 32.b Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 370 Value Multiples Price Multiple Fundamentals Justified price multiple: What the price multiple should be if the stock is fairly valued Also warranted and intrinsic price multiple  Actual = justified → properly valued  Actual < justified → undervalued  Actual > justified → overvalued© Kaplan, Inc. 44LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Market P/E Ratio Trailing P/E: Uses EPS from last year P0 E0 = market price per share EPS last 12 months Leading P/E: (forward or prospective): Uses forecasted earnings for coming year P0 E1 = market price per share forecast EPS next 12 months© Kaplan, Inc. 46 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples What You Need to Know!For relative valuation measures such as P/E, P/B,P/S, P/CF, and dividend yield, know the followingfor each ratio:  Rationale for using ratio  Possible drawbacks of ratio  Calculation of ratio  Fundamental influences  Calculate justified ratio  Evaluate a stock with the ratio© Kaplan, Inc. 45LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Example: Trailing and Leading P/E 20x1 earnings = $25 million Forecasted EPS over the next 12 months = $0.60 50 million shares outstanding Market price = $16 Calculate trailing and leading P/E ratios© Kaplan, Inc. 47ers - Exame CFA 12

LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value MultiplesSolution: Trailing and Leading P/EEPS20 x1  $25,000,000  $0.50 50,000,000trailing P/E  $16.00  32.0 $0.50leading P/E  $16.00  26.7 $0.60© Kaplan, Inc. 48LOS 32.e Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 162, CFAI V4 pg 374 Value Multiples Underlying EarningsGoal: Analysts want to remove nonrecurring itemsfrom earnings for forecasting purposesNonrecurring items to remove include:  Gains/losses on asset sales  Asset write-downs – impairment  Loss provisions (restructuring, etc.)  Changes in accounting estimatesResult: Persistent, continuing, and core earnings© Kaplan, Inc. 50 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Problems With Trailing P/EWhen calculating a P/E ratio using trailing earnings,care must be taken in determining the EPS number.The issues include:  Transitory, nonrecurring components of earnings that are company-specific  Cyclicality components of earnings due to business or industry trends  Differences in accounting methods  Potential dilution of EPS© Kaplan, Inc. 49LOS 32.e Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 162, CFAI V4 pg 374 Value Multiples Normalized Earnings Adjust EPS to remove cyclical component of earnings and capture mid-cycle or an average of earnings under normal market conditions Two normalization methods:  Method of historical average EPS  Method of average ROE © Kaplan, Inc. 51ers - Exame CFA 13

LOS 32.e Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 162, CFAI V4 pg 374 Value MultiplesExample: Normalized Earnings Year 20x5 20x6 20x7 20x8EPS $4.00 $3.80 $5.25 $4.50BVPS $25.00 $26.00 $26.00 $28.00ROE 15% 15% 21% 16%© Kaplan, Inc. 52LOS 32.e Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 162, CFAI V4 pg 374 Value Multiples Solution: Normalized EarningsIf the current stock price was $60, then thenormalized P/E ratios approaches are: Average EPS = $4.39 P/E = $60 / $4.39 = 13.7xAverage ROE method EPS = $4.69P/E = $60 / $4.69 = 12.8x  Preferred method because it more accurately 54 reflects the effect of growth and company size on EPS© Kaplan, Inc. ©2018 FK Partne













SS 11- Equity InvestmentsLOS 32.j,n Evaluate/Explain Price and EnterpriseSchweser B3 pg 171, CFAI V4 pg 387 Value Multiples Example: Method of ComparablesAre Alaska and Buffalo relatively over orundervalued? Stock Current 5-Year Beta P/E ConsensusAlaska Inc. 1.20Buffalo Inc. 20.2 Growth 1.20Industry average 16.3 1.20 22.7 15.4% 19.6% 19.4%© Kaplan, Inc. 65LOS 32.k Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 174, CFAI V4 pg 391 Value Multiples PEG Ratio PEG ratio is a stock’s P/E divided by the expected long-term earnings growth rate (g): PEG = PE Whole number, g not decimal Calculates a stock’s P/E per unit of expected growth  Lower PEG → more attractive valuation  Higher PEG → less attractive valuation 67© Kaplan, Inc.ers - Exame CFA 17

LOS 32.k Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 174, CFAI V4 pg 391 Value Multiples Example: PEG Ratio SGS Inc., leading P/E = 15 Five-year consensus long-term earnings growth rate forecast = 21% Median industry PEG = 0.90 Calculate PEG and explain whether the stock appears to be correctly valued, overvalued, or undervalued© Kaplan, Inc. 68LOS 32.k Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 174, CFAI V4 pg 391 Value Multiples Problems With PEG RatiosPEG ratio does not account for: Differences in firm risk attributes Differences in the duration of growth Nonlinear relationship between growth and the P/E ratio© Kaplan, Inc. 70 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.k Calculate/Interpret/Explain Price and EnterpriseSchweser B3 pg 174, CFAI V4 pg 391 Value Multiples Solution: PEG Ratio PEG = P/E = 15 = 0.71 Do not make growth g 21 rate a decimalComparable Industry PEG = 0.90 SGS PEG 0.71 < Industry PEG 0.90 Conclusion: SGS Inc., is undervalued. 69 SGS Inc., has a lower multiple per unit of expected growth.© Kaplan, Inc.LOS 32.l Calculate/Explain Price and EnterpriseSchweser B3 pg 175, CFAI V4 pg 400 Value Multiples Terminal Value Estimation Terminal value: value projected at end of estimation horizon Terminal value = (trailing P/E) × (earnings forecast) Two methods 1. Fundamentals: Requires estimates of g, r, and payout 2. Comparables: Uses market data to calculate benchmark© Kaplan, Inc. 71ers - Exame CFA 18

LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Price-to-Book Ratio P/B0 Book value per share (BVPS) attempts to represent the investment that common shareholders have made in the company BVPS is calculated as common equity divided by number of shares outstanding There is only a current P0/B0, not a leading P/B© Kaplan, Inc. 72LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Solution: Market Price to Book ValueBV per share  $200 million  $50 4 millionP/B ratio  $80  1.6 $50© Kaplan, Inc. 74 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Example: Market P/B0 Ratio P/B ratio  market value of equity book value of equity  market price per share book value per share  Market price = $80 73  Book value = $200 million  Shares O/S = 4 million Compute the P/B ratio.© Kaplan, Inc.LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Rationale for P/B0 RatioRationale Usually positive (even when EPS < 0) Less volatile, more stable than EPS Good for firms with mostly liquid assets (e.g., financial firms) Useful for distressed firms, liquidation Differences in P/B ratios explain differences in long-run average returns© Kaplan, Inc. 75ers - Exame CFA 19

LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Drawbacks of P/B0 RatioDrawbacks Does not reflect value of intangible assets, off- B/S assets (e.g., human capital) Misleading when comparing firms with significant differences in asset size Different accounting conventions obscure comparability (particularly international) Inflation and technological change can cause big differences between BV and MV© Kaplan, Inc. 76LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Justified P0/B0 RatioDerivation: Payout ratio D1/E1P0 = D1 D1= B0  ROE  1 – b r –g E1 Divide both sides by B0 P0 ROE  (1 b)P0 = B0  ROE  (1 b) B0 = r –g r –g P0 = ROE – g Multiply out numerator B0 r –g© Kaplan, Inc. 78 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Justified P0/B0 Ratio By using the Gordon growth model and using the expression g = b × ROE for the sustainable growth rate, the expression for the justified P/B ratio based on the most recent book value (B0) is: P0 = ROE – g B0 r –g E0 S0 Firms that earn ROE = r will have a P/B of 1.© Kaplan, Inc. 77LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Justified P0/B0 Ratio Based on Fundamentals: Example Return on equity = 22% Note the spread Expected growth rate = 6% between ROE Required return = 17% and rjustified P/B0 ratio  ROE – g  0.22 – 0.06  1.45 r –g 0.17 – 0.06© Kaplan, Inc. 79ers - Exame CFA 20

LOS 32.j,n Evaluate/Explain Price and EnterpriseSchweser B3 pg 171, CFAI V4 pg 387 Value MultiplesValuation Using Comparable P0/B0: ExampleStock 4 year Current ROE Beta meanA P/B forecast 1.22B P/B 1.26Industry 4.32 18.2% 6.85 3.35 19.9% 5.75 19.8% 8.62Based on the information given, which stocklooks the most attractive?© Kaplan, Inc. 80LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Rationale for Using P0/S0Rationale P/S useful for distressed firms Sales revenue is always positive Sales are generally more stable and less prone to distortion than EPS, over time P/S useful for mature, cyclical, and zero-income stocks Differences in P/S ratios may be related to difference in long-run average returns© Kaplan, Inc. 82 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.j,n Evaluate/Explain Price and EnterpriseSchweser B3 pg 171, CFAI V4 pg 387 Value Multiples Valuation Using Comparable P0/B0: Solution B is more attractive investment  Why?  B has lower P/B than A but a higher ROE  B’s P/B < industry P/B; B’s ROE ≈ industry ROE  P/B indicates potential undervaluation© Kaplan, Inc. To conclude that stock B is undervalued 81 relative to the industry, we would need to consider relative risk (not given).LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Drawbacks to Using P0/S0Drawbacks High sales growth does not translate to operating profitability P/S ratio does not capture different cost structures between firms Revenue recognition methods can distort reported sales and forecasts© Kaplan, Inc. 83ers - Exame CFA 21

LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Market P/S0 RatioP S = market value of equity total sales= market price per share sales per share© Kaplan, Inc. 84LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Justified P0/S0 Ratio E0Derivation: Net profit margin S0 Payout ratio D0 (1+g) b r –g P0= D0 = S0  margin  1 – E0P0 = S0  m arg in  (1 b)  (1 g) r –g P0 = m arg in  (1 b)  (1 g) Divide bothS0© Kaplan, Inc. r –g sides by S0 86 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value MultiplesJustified P0/S0 Based on Fundamental Factors      P0 S0  E0 / S0  1– b  1 g r –g P0  (net margin)  (trailing P/E) S0 Profit margin = E0/S0 Required return = r Payout = 1 – b Sustainable growth rate = g© Kaplan, Inc. 85LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Example: Justified P0/S0 Ratio Based on Fundamentals Payout ratio (Div/EPS) = 40% Required return on equity = 15% Expected growth in earnings = 8% Current net profit margin (E0/S0) = 12% P0/S0 = (0.12)(0.40)(1.08) / (0.15 – 0.08) P0/S0 = 0.74© Kaplan, Inc. 87ers - Exame CFA 22

LOS 32.j,n Evaluate/Explain Price and EnterpriseSchweser B3 pg 171, CFAI V4 pg 387 Value Multiples Valuation Using Comparable P0/S0 Same method as P/E and P/B Low P/S undervalued Use trailing sales to calculate In choosing comparables, control for:  Profit margin  Expected growth  Risk  Quality of accounting data© Kaplan, Inc. 88LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Drawbacks Against Using P/CF0Drawbacks Earnings plus noncash charges approach ignores some cash flows, such as net fixed investments, working capital investment, and net borrowings. FCFE is preferable to CFO, but FCFE is more volatile and more difficult to compute. FCFE can be negative with large CapEx.© Kaplan, Inc. 90 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Rationales for Using P/CF0Rationales More difficult to manipulate CF than EPS Cash flow is more stable than earnings Addresses quality of earnings problem Differences in P/CFs may explain differences in long-run average returns© Kaplan, Inc. 89LOS 32.m Explain/Describe Price and EnterpriseSchweser B3 pg 176, CFAI V4 pg 421 Value Multiples Market P/CF RatioP CF = market value of equity = market price per share total cash flow cash flow per shareCash flow measures:1. Traditional cash flow: NI + NCC2. CFO (from statement of cash flows)3. Adjusted CFO: CFO + [interest × (1 – t)]4. EBITDA (also used for EV/EBITDA ratio)5. FCFE: Theoretically superior© Kaplan, Inc. 91ers - Exame CFA 23

LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Justified P/CF Two-Step Process: Step 1: Calculate stock value using suitableDCF model:  V0 = FCFE0 1+ g r –g Step 2: Divide result by cash flow: Justified P/CF = V0 / CF© Kaplan, Inc. 92LOS 32.n Calculate/Interpret/Evaluate Price and EnterpriseSchweser B3 pg 177, CFAI V4 pg 428 Value Multiples EV / EBITDA RatioEnterprise Value (EV) or Firm Value: = MV of common stock + MV of debt* + MV preferred + minority interest – cash and investments * Book value used if market value is unavailableEBITDA: = earnings before interest, taxes, depreciation, and amortization Ratio provides an indication of company/firm value, not equity value© Kaplan, Inc. 94 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.n Calculate/Interpret/Evaluate Price and EnterpriseSchweser B3 pg 177, CFAI V4 pg 428 Value Multiples P/EBITDA or EV/EBITDA? EBITDA is an earnings flow to both debt and equity holders A multiple using total company value: Enterprise Value (EV) in the numerator is logically more appropriate than equity market price (P) Because the numerator is enterprise value, EV/EBITDA is a valuation indicator for the overall company rather than common stock© Kaplan, Inc. 93LOS 32.n Calculate/Interpret/Evaluate Price and EnterpriseSchweser B3 pg 177, CFAI V4 pg 428 Value Multiples Rationale EV/EBITDARationale Comparing firms with different financial leverage since EBITDA is pre-interest Controls for depreciation/amortization differences EBITDA usually positive when EPS is negativeDrawbacks: Ignores changes in WC investments FCFF (which controls for CapEx) is more closely tied to value© Kaplan, Inc. 95ers - Exame CFA 24

LOS 32.n Calculate/Interpret/Evaluate Price and EnterpriseSchweser B3 pg 177, CFAI V4 pg 428 Value Multiples EV/EBITDA: ExampleMetric € Metric €Share price 15.50 Short-term 60 million investments 175 millionShare 20 million Net income 20 millionoutstanding 25 millionMarket value 220 million Interest 80 millionof debt expenseCash & 50 million Depreciation &equivalents amortization Tax© Kaplan, Inc. Compute the EV/EBITDA multiple. 96LOS 32.n Calculate/Interpret/Evaluate Price and EnterpriseSchweser B3 pg 177, CFAI V4 pg 428 Value Multiples Valuation Using EV/EBITDA Firm EV/EBITDA < benchmark = undervalued Firm EV/EBITDA > benchmark = overvalued© Kaplan, Inc. 98 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.n Calculate/Interpret/Evaluate Price and EnterpriseSchweser B3 pg 177, CFAI V4 pg 428 Value Multiples EV/EBITDA: Solution+ Net Income €m + MV equity €m+ Tax provision 175 + MV debt 310+ Interest expense – Cash & securities 220+ Dep’n & amort. 80 – Investments (50)EBITDA 20 Enterprise value (60) 25 420 300MV equity = €15.50 × 20m = €310m Enterprise value = €420m =1.4x EBITDA €300m© Kaplan, Inc. 97LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Arguments For Using D0/P0 Dividend yield is a component of total return Dividends are a less risky component of total return than capital appreciation © Kaplan, Inc. 99ers - Exame CFA 25

LOS 32.c,d Describe/Calculate/Interpret Price and EnterpriseSchweser B3 pg 156, CFAI V4 pg 372 Value Multiples Market Dividend Yield (D/P)trailing D/P  4  most recent quarterly DIV market price per shareleading D/P  next 4 quarters forecasted DIVs market price per share For practical purposes, dividend yield D/P ispreferred over P/D (zero dividends are a problem).© Kaplan, Inc. 100LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Example: Justified Dividend Yield D0/P0 Required rate of return on equity = 10% Long-term earnings growth = 5%  D0/P0 = D0 = r – g P0 1+ g (0.10 – 0.05) / (1.05)  D0/P0 = 0.048 or 4.8%© Kaplan, Inc. 102 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Justified Dividend Yield D0/P0 The justified dividend yield in a Gordon model is: D0 = r– g P0 1+ gDerivation: Divide both sides by D0:P0 = D0 (1+g) P0 = 1+g Invert r –g D0 r –g© Kaplan, Inc. 101LOS 32.g,h Calculate/Interpret Price and EnterpriseSchweser B3 pg 165, CFAI V4 pg 384 Value Multiples Fundamental Factors Affecting D0/P0Dividend yield increases as:  Required return increases (price falls)  High growth rate decreases the firms payout and therefore the firm is less able to pay dividends, which results in a lower D/P ratio Note that high dividends today displaces future dividends (lower earnings growth)  High D/P strategy = value strategy© Kaplan, Inc. 103ers - Exame CFA 26

LOS 32.j,n Evaluate/Explain Price and EnterpriseSchweser B3 pg 171, CFAI V4 pg 387 Value MultiplesValuation Using Comparable D/P Consensus Beta D/P GrowthSW 9% 0.71 8%UtilitiesNE 6% 0.74 5%UtilitiesWhich stock is preferred?  SW Utilities is preferred 104  Lower risk; higher total expected return© Kaplan, Inc.LOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Defining Residual Income Residual income (RI):  Equivalent to economic profit  RI = net income less opportunity cost of equity capital Accounting income will overstate returns from equity investor perspective because ignores cost of equity Residual income explicitly deducts all capital costs of both debt and equity© Kaplan, Inc. 106 ©2018 FK Partne

SS 11- Equity Investments Fixed Income Investments Equity Equity Investments Valuation Models 33. Residual Income ValuationLOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Residual Income (RI) Residual income has close links to other valuation models already covered:  PVGO model: P = EPS1/r + PVGO  P/B ratio using fundamentals:  P/B = (ROE – g)/(r – g)  The five forces model and competitive strategies© Kaplan, Inc. 107ers - Exame CFA 27

LOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Defining Residual IncomeUsing a post-levered figure:RI = net income – (equity capital × cost of equity)Alternatively, using a pre-levered figure:RI = EBIT(1 – t) – (total capital × WACC%)Recall, WACC implicitly accounts for both the cost ofdebt and equity on a weighted-average basis.© Kaplan, Inc. 108LOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Example: Residual IncomeThe Maisy Grain Company makes gourmet breadproducts  Assets = $100.8 million  Debt = $40.2 million  Equity = $60.6 million  Pretax cost of debt = 7.1%  Cost of equity = 13.3%  Tax rate = 40%Calculate residual income from EPS or EBIT© Kaplan, Inc. 110 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Residual Income Calculation: ExampleEstimated 2009 EPS = $1.20Book value per share 2008 = $10.00Equity required return = 10%Calculate Residual Income: RI = EPS1 – (BVPSt–1 × r) $0.20 = $1.20 – ($10.00 × 0.10) The firm earned positive RI of $0.20 providing value to both debt and equity holders© Kaplan, Inc. 109LOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Solution: Calculation of Residual Income Maisy Grain Company – Partial Income Statement EBIT $7,560,000 Less: Interest expense 2,854,000 Pre-tax income 4,706,000 Less: Income tax expense 1,882,400 Net income $2,823,600© Kaplan, Inc. 111ers - Exame CFA 28

LOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Solution: Calculation of Residual Income Equity charge = equity capital × cost of equity = $60.6 million × 0.133 = $8,059,800 RI = net income – equity chargeRI = $2,823,600 – $8,059,800RI = –$5,238,200 Positive accounting income; negative economic income© Kaplan, Inc. 112LOS 33.c Calculate/Compare Residual IncomeSchweser B3 pg 203, CFAI V4 pg 485Intrinsic Value and Residual Income RI approach: Value = BV + PV all future RI General formula similar to DDM: Book value of equity  RIt =Et – r  Bt–1 V0 = B0 +  RI1 + RI2 + RI3 +...  (1+ r)1 (1+r)2 (1+r)3  © Kaplan, Inc. PV of expected future residual income 114 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.a Calculate/Interpret Residual IncomeSchweser B3 pg 200, CFAI V4 pg 481 Solution: Calculation of Residual Income EBIT (1 – t) = $7,560,000 × (1 – 0.40) = $4,538,000 Total capital (TC) = $100,800,000 WACC = re × (E/TC) + id (1 – t)(D/TC) WACC = (0.133)(0.601) + (0.071)(1 – 0.4) (0.399) = 9.6930% RI = EBIT (1 – t) – (Total cap × WACC%) RI = $4,538,000 – $9,770,584 = –$5,234,584© Kaplan, Inc. 113LOS 33.c Calculate/Compare Residual IncomeSchweser B3 pg 203, CFAI V4 pg 485 Calculating Future RI Two methods for calculating Rit 1. RIt = EPSt – (r × BVt–1) 2. RIt = (ROEt – r) × BVt–1 With a little substitution: = B0 +  (ROEt – r)  Bt-1 V0 t=1 (1 + r)t© Kaplan, Inc. 115ers - Exame CFA 29

LOS 33.c Calculate/Compare Residual IncomeSchweser B3 pg 203, CFAI V4 pg 485Example: Intrinsic Value and Residual Income Assume:  Required return on equity = 12%  BV/share = $3.40 beg of 20x1  Earnings forecast: 20x1 = $0.90; 20x2 = $1.10; 20x3 = $1.20  Payout ratio = 50%  Dividend in 20x3 is liquidating event Calculate: Intrinsic value using RI model© Kaplan, Inc. 116LOS 33.c Calculate/Compare Residual IncomeSchweser B3 pg 203, CFAI V4 pg 485Solution: Intrinsic Value and Residual Income Calculate the PV (using calculator) CF0 = +3.40 (current BV) CF1 = +0.49 (RI1) CF2 = +0.64 (RI2) CF3 = +0.67 (RI3) I = 12 (%) CPT  NPV = $4.82 = equity value today© Kaplan, Inc. 118 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.c Calculate/Compare Residual IncomeSchweser B3 pg 203, CFAI V4 pg 485Solution: Intrinsic Value and Residual Income Beginning BV/share (Bt–1) 20x1 20x2 20x3 EPS forecast (Et) $3.40 $3.85 $4.40 DPS forecast (Dt) – 50% payout 1.10 BV/share forecast (Bt–1 + Et – Dt) 0.90 (0.55) 1.20 (0.45) (5.60) Equity charge/share (r × Bt–1) 4.40 RI/share (Et – (r × Bt–1)) 3.85 0.46 0.0 0.41 0.64 0.53© Kaplan, Inc. 0.49 0.67 117LOS 33.c Calculate/Compare Residual IncomeSchweser B3 pg 203, CFAI V4 pg 485 Difference in Value Recognition: Between RI vs. DCF Models Value is recognized earlier under RI model (BV0) than under the DCF model, therefore less sensitive to terminal value estimates BV0 usually represents a large percentage of intrinsic value In the DDM or FCF model, terminal value is most of the value estimate, which is subject to substantial forecasting risk due to the forecast horizon and the relationship between r and g© Kaplan, Inc. 119ers - Exame CFA 30

LOS 33.d Explain Residual IncomeSchweser B3 pg 206, CFAI V4 pg 493Value Drivers of Residual Income Main point: If ROE > required return:  RI will be positive  Justified market-to-book > 1 If ROE = required return:  Justified market value = book value  Market-to-book ratio = 1© Kaplan, Inc. 120LOS 33.e Explain Residual IncomeSchweser B3 pg 207, CFAI V4 pg 493Price to Book Reconciled to RI ModelP0 ROE – g Add and subtract the costB0 r– g = of equity to the numerator P0 = ROE – g + r -r B0 r –gRearrange the numeratorP0 = ROE – r  +r - g  P0 =1+ ROE – rB0 r –g B0 r –g Multiply both sides by B0 to arrive at  B0  ROE – r the single stage RI model: P0 = B0 +  r –g © Kaplan, Inc.  122 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.f Calculate/Interpret Residual IncomeSchweser B3 pg 207, CFAI V4 pg 494 Constant Growth Residual IncomeSingle-stage RI assumes: Just the fundamental  Constant ROE price to book ratio rearranged  Constant earnings growth: RI1   V0 = B0 +   ROE – r  B0  r –g   Value generated by firm’s ability to 121 produce economic profits when ROE > r© Kaplan, Inc.LOS 33.f Calculate/Interpret Residual IncomeSchweser B3 pg 207, CFAI V4 pg 494 Example: Single-Stage Residual Income North Pacific Whaling Co:  Book value $37.00 Positive spread  ROE 23% between ROE and r  Required return 18%  Dividend payout 40% Calculate: Share value using single-stage RI model© Kaplan, Inc. 123ers - Exame CFA 31

LOS 33.f Calculate/Interpret Residual IncomeSchweser B3 pg 207, CFAI V4 pg 494Single-Stage Residual Income: Solution Growth rate: g = b  ROE = (1– 0.40)  0.23 = 0.1380 = 13.8% Intrinsic value:   V0 = $37.00 +   0.23 – 0.18  $37.00   0.18 – 0.138  = $81.05 124© Kaplan, Inc.LOS 33.g Calculate Residual IncomeSchweser B3 pg 208, CFAI V4 pg 495 Solution: Calculating Implied Growth Rate Market price = P/B × BVPS Market price = 1.50 × $9.00 = $13.50 Solving for the implied growth rate… g  0.10 –  $9.00  0.12 – 0.10     0.06  6%  $13.50 – $9.00 © Kaplan, Inc. 126 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.g Calculate Residual IncomeSchweser B3 pg 208, CFAI V4 pg 495 Example: Calculating Implied Growth Rate Market P/B ratio = 1.50 Current book value per share B0 = $9 Estimated ROE = 12% Required return on equity = 10% Assume P0 = V0, market is in equilibrium g  r –  B0  ROE – r      V0 – B0 © Kaplan, Inc. 125LOS 33.h Explain/Justify Residual IncomeSchweser B3 pg 209, CFAI V4 pg 495 Continuing Residual Income Continuing RI: Expected RI beyond the estimation horizon  Depends on firm’s ability to generate ROE > r, premium over BV  Usually fades towards industry mean  Based on trends in industry ROE © Kaplan, Inc. 127ers - Exame CFA 32

LOS 33.h Explain/Justify Residual IncomeSchweser B3 pg 209, CFAI V4 pg 495 Continuing Residual Income Measured by persistence  Persistence factor = ω, between 0 and 1  Higher persistence (closer to 1) means longer period where ROE > r (higher firm valuation) Factors suggesting Factors suggesting 128 higher ω: lower ω:  Low dividend payout Extremely high:  High RI industry  Accounting ROE persistence  Special items  Accruals© Kaplan, Inc.LOS 33.h Explain/Justify Residual IncomeSchweser B3 pg 209, CFAI V4 pg 495Multi-Stage Residual Income Model Intrinsic value = sum of three components:V0 = B0 + (PV high-growth RI) + (PV cont. RI) Three parts:1. (Calculate current BV) +2. (Calculate RI for years 1 through T – 1) +3. (Calculate continuing RI) as:  PV = RIT cont RI in yr. T – 1 1+ r – © Kaplan, Inc. 130 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.h Explain/Justify Residual IncomeSchweser B3 pg 209, CFAI V4 pg 495 Continuing Residual Income Possible approaches for continuing RI: 1. Drop immediately to zero (ω = 0), no competitive advantage, pure competition 2. Persist at current level forever (ω = 1), perpetual competitive advantage 3. Decline over time to zero (0 < ω < 1) 4. Decline to mature industry level© Kaplan, Inc. 129LOS 33.h Explain/Justify Residual IncomeSchweser B3 pg 209, CFAI V4 pg 495 Multi-Stage Model—Continuing RI Approach 1: Drop to zero (ω = 0)  PV = RIT RIT cont RI in yr. T – 1 1+ r – 0  1+ r Approach 2: Current level forever (ω = 1)  PV = RIT RIT cont RI in yr. T – 1 1+ r – 1  r© Kaplan, Inc. 131ers - Exame CFA 33

LOS 33.h Explain/Justify Residual IncomeSchweser B3 pg 209, CFAI V4 pg 495Multi-Stage Model—Continuing RI Approach 3: Decline slowly to 0 (0 < ω < 1) PV RIT cont RI in yr. T – 1 = 1+ r –  Approach 4: Mature industry market value = book value + PV cont RI in yr. T  PV cont RI in yr. T = PT – BT  PV = (PT – BT ) + RIT cont RI in yr. T – 1 1+ r© Kaplan, Inc. 132LOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495Multi-Stage Model (Approach 1) Period T-1 in model Period T in model Beginning BV (Bt–1) Year 1 Year 2 Year 3 Year 4 $8.00 9.60 11.52 13.82 Bt-1× ROE 20% (Et) 11..6600 1.92 2.30 0 0 2.76 DPS forecast (Dt) 00 11.52 13.82 0 (Bt–1 + Et – Dt) 99..6600 1.44 1.73 11..2200 0.48 0.57 16.58 (r × Bt–1) r = 15% 00..4400 2.07 RI/share (Et – (r × Bt–1)) 0.69© Kaplan, Inc. 134 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495 Example: Multi-Stage ModelFastShip Data:  ROE of 20% per year for four years  BV0 = $8.00  No dividends  Required return = 15%  Forecast earnings = BV0 × ROE (by definition)CI approach #1: After four years RI = 0Calculate: Intrinsic value© Kaplan, Inc. 133LOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495 Multi-Stage Model (Approach 1) PV (continuing RI Year 3) = 0.69 / 1.15 = 0.60 Calculate intrinsic value:  CF0 = 8.00 T0 T1 T2 T3 0.40 0.48 1.17  CF1 = 0.40  CF2 = 0.48 $8.00  CF3 = 0.57 + 0.60 = 1.17  I = 15% (given)  CPT  NPV = $9.48 (lowest value) 135© Kaplan, Inc.ers - Exame CFA 34

LOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495Multi-Stage Model (Approach 2) Change continuing RI assumption:  Assume: Constant residual income of $0.69 after three years, think perpetuity  Include the PV of RI for Years 4 to infinityPV (continuing RI year 3) = 0.69 / 0.15 = 4.60© Kaplan, Inc. 136LOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495Multi-Stage Model (Approach 3) Change Continuing RI assumption:  Assume: Starting in Year 4 RI will decrease to zero over time with a persistence factor of 0.6 Cont RI3 = $0.69 = $1.25 1+ 0.15 – 0.6Notice we stop one year earlier in Year 3 not Year 4 because it’s the PV of RI in t – 1!© Kaplan, Inc. 138 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495 Multi-Stage Model (Approach 2) Calculate intrinsic value:  CF0 = 8.00 T0 T1 T2 T3 0.48 5.17  CF1 = 0.40 $8.00 0.40  CF2 = 0.48  CF3 = 0.57 + 4.60 = 5.17  I = 15% (given) CPT  NPV = $12.11 (highest value)© Kaplan, Inc. 137LLOOSS333.3h .hExpElaxipn/lJauinst/iJfyustify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495 Multi-Stage Model (Approach 3) Calculate intrinsic value:  CF0 = 8.00 T0 T1 T2 T3 0.40 0.48 1.82  CF1 = 0.40 $8.00  CF2 = 0.48  CF3 = 0.57 + 1.25 = 1.82  I = 15% (given) CPT  NPV = $9.91© Kaplan, Inc. 139ers - Exame CFA 35

LLOOSS333.3h .hExpElaxipn/lJauinst/iJfyustify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495Multi-Stage Model (Approach 4) Change continuing RI assumption:  Assume: At t = 4 price-to-book falls to 1.1 From table MP = 10% premium over BV BV4 = $16.58, P4 = 1.1 × $16.58 = $18.24 PV4 of RI after yr. 4 = $18.24 – $16.58 = $1.66 Cont RI3 = $0.69 + $1.66 = $2.04 1.15 140© Kaplan, Inc.LOS 33.j Explain/Justify Free Cash Flow ValuationSchweser B3 pg 215, CFAI V4 pg 502Strengths of Residual Income Model1. Terminal value does not dominate intrinsic value estimate2. Accounting data usually accessible3. Applicable even without dividends or positive cash flow4. Applicable even when cash flows are volatile or unpredictable5. Focus on economic profitability© Kaplan, Inc. 142 ©2018 FK Partne

SS 11- Equity InvestmentsLOS 33.h Explain/Justify Free Cash Flow ValuationSchweser B3 pg 209, CFAI V4 pg 495 Multi-Stage Model (Approach 4) Calculate intrinsic value:  CF0 = 8.00 T0 T1 T2 T3 0.40 0.48 2.61  CF1 = 0.40  CF2 = 0.48 $8.00  CF3 = 0.57 + 2.04 = 2.61  I = 15% (given) CPT  NPV = $10.43© Kaplan, Inc. 141LOS 33.j Explain/Justify Residual IncomeSchweser B3 pg 215, CFAI V4 pg 502 Weaknesses of the Residual Income Model1. Accounting data can be manipulated by management2. Requires many adjustments (link to FRA)3. Assumes clean surplus relation holds or that its failure to hold has been taken into account (link to FRA): RI assumes no Bt = Bt –1 + Et – Dt adjustments directly to equity 143© Kaplan, Inc.ers - Exame CFA 36