2022 CFA Level 2
Equity Investment
Lecture note
유태인, CFA
yootaein.cfa@gmail.com
Contents
Study Session 9
Eq valuation(1)
Study Session 10
Eq valuation(2)
Study Session 11
Eq valuation(3)
LOS 20
Valuation : Applications & Processes
04
LOS 21
Return concept
12
LOS 22
Industry & company analysis
20
LOS 23
Discounted Dividend Valuation
25
LOS 20
Free Cash Flow Valuation
32
LOS 21
Market-Based Valuation
39
LOS 22
Residual Income Valuation
48
LOS 23
Private Company Valuation
55
Study Session 8
LOS 20 Valuation : Applications & Processes
LOS 21 Return concept
LOS 20 Valuation : Applications & Processes
a. Valuation
Intrinsic Value
Asset Value Given a Complete Understanding of an Asset’s Characteristics
“True” or “Real” Value
Not Always Equal to Market Price
Asset Mispricing
Efficient Market Theory
•Intrinsic value = Market price
V E – P = ( V – P) + ( V E – V )
•Sources of perceived mispricing
•(V – P) : True mispricing = Market error
•(VE – V) : Valuation error = Analyst error
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LOS 20 Valuation : Applications & Processes
b. Going Concern vs. Liquidation Value
Going concern value
-Firm will continue in its business activities
Liquidation value
-Firm will be dissolved →Firm assets will be sold separately
Going concern value > Liquidation value
-Value added from asset synergy
c. Fair Market Value vs Investment Value
Fair Market Value
• Well-informed, willing buyer and seller
Fair Value
• Financial reporting
Investment Value
• Value to specific buyer - synergy
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LOS 20 Valuation : Applications & Processes
d. Uses of Equity Valuation
Stock Selection
Inferring Market Expectations
Evaluating Corporate Events
Fairness Opinions
Evaluating Business Strategies
Communicating with Analysts and
Shareholders
Appraising Private Businesses
Compensation
•Is the stock under- or overvalued?
•What does the security price say about expectations?
•What is the effect on firm value from a merger?
•Is the value paid for the firm fair?
•What is the effect on firm value of a new strategy?
•How is firm value being affected?
•What is the value of a private firm?
•What is the value of equity compensation?
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LOS 20 Valuation : Applications & Processes
d. Uses of Equity Valuation- The Valuation Process
1. Understanding the Business – LOS24
Industry and competitive analysis
Financial statement analysis
2. Forecasting Company Performance – LOS26
Forecast sales, earnings, dividends, and financial position
3. Selecting the Appropriate Valuation Model – Absolute or Relative – LOS24 f/g/h
Base selection on company characteristics
4. Using Forecasts in a Valuation – LOS27~31
Use judgment in valuation application
5. Applying the Valuation Conclusions – Over or Under valued? – LOS27~31
Investment recommendations
Valuation opinions
Strategic decisions
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LOS 20 Valuation : Applications & Processes
e. Industry Analysis
Porter’s Competitive Advantage
→ LOS22. g/h
Low Cost
Differentiation
New
Entrants
Broad
Target
Market
Supplier
Power
Rivalry
Cost
Leadership
Differentiation
Buyer
Power
Narrow
Target
Market
Cost
Differentiation
Focus
Focus
Substitutes
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LOS 20 Valuation : Applications & Processes
e. Industry Analysis
Quality of Earnings Examples
Case
Rev 과다/조기 인식
Exp 과소/지연 인식
영업↔영업외 항목 변경
Off-B/S
회계추정의 변경
Example & Potential Interpretation
- Firm A recognizes revenue early using bill-and-hold sales
- Potentially poor underlying performance, reported income , and future income 
- Firm B capitalizes product development expenses
- Potentially poor underlying performance, reported income , and future income 
- Rev : Non-Operating → Operating
- Exp : Operating → Non-Operating
- Firm C has large amounts of off-balance-sheet financing
- Liabilities are understated
- Firm D increases its loan-loss reserves
- Current income  so as to inflate future performance
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LOS 20 Valuation : Applications & Processes
f. Valuation Models
Absolute Valuation Models
•Present value models : V = PV of future CFs
Relative Valuation Models
•Price multiples
•Dividend discount models
•Price-to-earnings ratio
•Free cash flow to equity
•Price-to-book-value ratio
•Free cash flow to the firm
•Price-to-cash-flow ratio
•Residual income
•Enterprise value multiples
•Asset-based models : Liquidation, Natural Resources
g. Sum-of-the-parts Valuation
▪ value a firm as the sum of its individual operating segments
▪ conglomerate discount : conglomerates can be inefficient and poorly managed
▪ Internal Capital Inefficiency
▪ Endogenous factors
▪ Research measurement error
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LOS 20 Valuation : Applications & Processes
h. Selecting appropriate model
What are the characteristics of the company?
What is the availability and quality of data?
What is the purpose of the valuation?
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LOS 21 Return concept
a. holding period return, realized return and expected return, required return, discount rate,
the return from convergence of price to intrinsic value
Holding Period
Return from Convergence
Return
of Price to Intrinsic Value
𝐻𝑃𝑅 =
𝑃1 + 𝐷1
−1
𝑃0
𝐷1 𝑃1 − 𝑃0
=
+
𝑃0
𝑃0
𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
= 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 +
Required Return
Discount Rate
Internal Rate of Return
𝑉−𝑃
𝑃
b. Equity Risk Premium
Current expected
risk-free return
Equity risk premium
Required return on
equity
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LOS 21 Return concept
b. Equity Risk Premium
Historical Estimates
Forward-Looking Estimates
ERP=Equity market Index return - Rf
1)Gordon growth model estimates
ERP = D/P + g – Rf(LT Gov.yield)
* ISSUE
•Return의 mean/variance가 constant 가정
•-실제로는 counter cyclical→ US empirical
•-Bad times에 ERP↑, good times에 ERP ↓
•Survivorship bias - ERP↑
•Geometric vs. Arithmetic Mean
→ Arithmetic Mean ERP↑
•Risk-Free Return : T-bond(long term) vs. T-bill(sh
2)Macroeconomic model estimates
ERP={[(1+inf)(1+rEg)(1+P/Eg)-1]+D/P}-Rf
Expected Inflation = (1+T-bond YTM)÷(1+TIPS YTM)
Expected real earnings growth = real GDP growth
=labor productivity growth + labor supply growth
Expected growth in the P/E- if overvalued P/E<0, und
ervalued P/E>0(미래 P/E 상승 예상)
ort term) - T-bill 사용 시 ERP↑(upward sloping
yield curve 가정 시)
3)Survey estimates
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LOS 21 Return concept
c. Estimating the Required Return
Capital Asset Pricing Model
•
E ( Ri ) = RF + i [ E ( RM ) − RF ],
Multifactor Models
•Fama–French model
•Pastor–Stambaugh model
•Macroeconomic models
Build-Up Method
•Private Firms
•Bond Yield plus Risk Premium Method
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LOS 21 Return concept
c. Estimating the Required Return
Multifactor Models
• ri = RF + βi RMRF + βi SMB + βi
mkt
Fama–French model
value
HML,
• SMB = The return to small stocks minus the return to large stocks
• βsize = The sensitivity of security i to movements in small stocks
• HML = The return to value stocks minus the return to growth stocks
• β value = The sensitivity of security i to movements in value stocks
• ri = RF + βi RMRF + βi SMB + βi
mkt
Pastor–Stambaugh model
size
size
value
HML + βiliq LIQ,
• LIQ = The return to illiquid stocks minus the return to liquid stocks
• β liq = The sensitivity of security i to movements in illiquid stocks
• ri=Rf
• + βcconfidence risk - unexpected change in (20yr T-bond – Corp. bond)
Macroeconomic models ;
Burmeister, Roll&Ross Model
• + βTTime horizon risk - unexpected change in (T-bond – T-bill)
• + βiInflation risk - Inflation
• + βBBusiness cycle risk- unexpected change in (expected growth rate-real business activity)
• + βMMarket Timing risk - unexpected change in (위의 4가지로 설명되지 않는 부분)
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LOS 21 Return concept
c. Estimating the Required Return
Build-Up Methods
Private Firms
ri=Rf + Equity risk premium + size premium + firm-specific risk premium + Other risk premiums*
* Other risk premiums : marketability / control → risk premiums 보다는 Value에 직접 영향
Bond Yield + Risk Premium
YTM on long-term debt + risk premium
Useful if firm has public debt
d. Beta
Choice of Market Index
Length & Frequency of Data
Adjusted Betas
•S&P 500 and NYSE Composite are common choices in the United States
•Five years of monthly data is most common choice
• Adjusted β = (2/3)*unadjusted β + (1/3)*1 - Betas move towards 1.0 over time
•Adjust comparable betas for leverage
Thinly Traded and Private Firms
βu = [
1
𝐷
1+𝐸
]βe ➔ βe= [1+
𝐷
]β
𝐸 u
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LOS 21 Return concept
e. Strengths vs Weakness
Strengths
Weakness
CAPM
Simple
설명력↓
Multi-market 일 때 다수의 required return
Multi-factor Model
설명력↑
Complex & expensive
Build-up Method
Simple, 비상장사 적용가능
Historical data 사용
f. International Issues
⚫ Exchange Rates, Data issues
⚫ Emerging Markets
▪ Country spread model
Emerging ERP = Developed equity risk premium + Country premium (emerging mkt bond yield – developed mkt bond yield)
▪ Country risk rating model
Developed mkt 의 risk rating(독립변수)와 ERP(종속변수)를 회귀분석 → emerging mkt 의 risk rating을 대입하여 ERP 추정
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LOS 21 Return concept
g. WACC
Marginal tax rate
D
E
WACC = D+ E × rd × (1 − 𝑡) + D+ E × re
Market value, Target weight
h. Appropriate Discount Rate
Cash Flows to the Firm
•WACC
Cash Flows to Equity
•Required return on equity
Nominal Cash Flows
•Nominal discount rates
Real Cash Flows
•Real discount rates
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Study Session 9
LOS 22 Industry & company analysis
LOS 23 Discounted Dividend Valuation
LOS 22 Industry & company analysis
a. Top-down / Bottom-up / Hybrid Approach
▪ Top-down Approach : Overall economy→Industry→company, ex> GDP 대비 % 로 추정
▪ Bottom-up Approach : Company or division(location, segment…), ex> Time series(과거평균), 자산 대비 Rev(은행 등), Capacity-based(백화점
등 - 매장 수 × 면적)
▪ Hybrid Approach : 가장 빈번하게 활용. 한가지 approach만을 사용할 때의 error 밝히는데 유용
b. Revenue forecasting
▪ Growth relative to GDP growth : Sales growth = nominal GDP growth rate + 2% or GDP growth ×(1+20%)
▪ Market growth & market share : 시장성장율 추정 + 회사 MS추정 ex>패션시장 규모 40조원 ×5% 성장 =42조원 × MS 10% = 4.2조원
▪ 위의 2가지 모두 Top-down 방식. 만약 hybrid라면 Business segment 의 매출 추정 후 aggregate
c. Economies of scale
▪ Sales↑ → avg.Cost ↓
▪ Larger company → larger margin(매출원가율/판관비율 ↓) → economies of scales
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LOS 22 Industry & company analysis
d. Forecast CoGS / SG&A / Financing cost / Tax
▪ COGS = 추정매출액 × 매출원가율
✓ GPM 차이 : 경쟁력 / 사업모델
✓ 정교한 분석을 위해 1)price와 volume을 구분하여 분석, 2)Hedge 고려, 3)제품별/사업부문별 분석
▪ SG&A
✓ COGS 보다 매출 변화에 덜 민감 – 인건비, R&D 비용 등 고정비 성격
✓ 구성항목별, 사업부분별 별도 추정
Sales
---
100
CoGS
---
(60)
✓ Gross debt – cash/ CE /ST securities = Net debt
Gross profit
---
40
✓ Gross interest expense – Interest income = Net interest expense
SG&A
---
(20)
Operating profit
---
20
▪ Financing cost = debt level × interest rate
COGS/S=60%
GP/S=40%-GPM
OP/S=20%-OPM
▪ Tax
✓ Statutory tax rate : 법정세율
✓ Effective tax rate : 실효세율(=법인세비용/EBT)
✓ Cash tax rate : 현금세율(=현금법인세/EBT)
✓ Tax expense = cash tax + ΔDTL (–ΔDTA), [T𝑎𝑥 exp/𝐶𝑎𝑠ℎ, 𝐷𝑇𝐿]
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LOS 22 Industry & company analysis
e. B/S modeling
B/S
▪ ΔWC : Sales와 연동
✓ Inventory = COGS(F) / Inv. TO
(2)
ΔWC
ΔPPE
✓ A/R = Sales(F) / AR.TO = days × sales(F) / 365
(1)
ΔR/E
= NI - Div
▪ ΔPPE = CAPEX - Dep
✓ CAPEX : Maintenance CAPEX vs growth CAPEX
f. ROIC vs ROCE
ROIC =
NOPLAT ≒ NOPAT(EBIT(1−t))
Invested Capital
EBIT
ROC𝐸 = Invested Capital
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LOS 22 Industry & company analysis
g. Competitive factors ➔ Price/Cost
h. Judge competitive position
i. Inflation/Deflation → Sales/Cost
Rev(Sales)
(-) Cost
= P↑ × Q ↓
→ 관리(Hedge. 수직적 통합 등)
Gain/Loss
▪ 가격인상 시 Demand elasticity에 대한 고려 필요 : price 상승 시 탄력적이라면 Revenue 하락, 비탄력적이라면 Revenue 상승
▪ Price-volume trade-off : inflation 상황에서 가격 인상 늦으면 profit margin↓ (M/S↑), 빠르면 profit margin 유지되나 volume↓
i. Technological development
▪ Cost ↓ → profit margin ↑
▪ 대체제 개발 → 수요↓( cannibalization)
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LOS 22 Industry & company analysis
k. Forecast horizon
▪ Holding period : (if) portfolio turnover 20~25% → 4~5yr
▪ Cyclicality : mid-cycle sales/profit 포함하여 추정. Normalized earning
▪ Company specific event : M&A, restructuring 등의 event 효과 반영되어야
▪ Employer preference
l. Long-term Forecasting
▪ Terminal value의 추정
▪ 1)Multiple, 2)DCF(GGM)의 2가지 방식
m. Sales based pro forma F/S
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LOS 23 Discounted Dividend Valuation
a. Compare Dividend / FCF/ Residual Income
Strengths
Weakness
Dividend discount model
이론적으로 우수
Less volatile
배당 없는 회사 적용 불가
소액주주 관점
Free cash flow model
배당정책/자본구조와 무관하게 사용 가능
지배주주 관점
CAPEX↑→ (-)FCF면 적용 어려움
Residual income model
배당 없거나 (-)FCF 상황에도 적용 가능
투명한 회계처리 전제
Choice of Discounted Cash Flow Models
Dividend discount model
History of dividend payments
Dividends related to earnings
Noncontrolling perspective
Free cash flow model
Small or zero dividends
Positive cash flow related to earning
Controlling perspective
Residual income model
Small or zero dividends
Negative free cash flow
High quality accounting disclosures
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LOS 23 Discounted Dividend Valuation
b. DDM → c. GGM
D
1
GGM : V0 = r − g
d. preferred stock
V0 =
Dp
rp
e. Implied growth rate
▪ Price, r, D0가 주어졌을 때 투자자들이 생각하는 “g”
V0 = 𝑃 =
D0(1+g)
r−g
3가지 변수를 알면 g 역산
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LOS 23 Discounted Dividend Valuation
f. PVGO
Stock value
(1) No growth value
(2) PVGO
V0 =
E1
r + PVGO
PVGO = P0 −
E1
r
g. Justified P/E
D1/E1
1−b
∗ Justified leading P0/E1 = r −
=
g
r−g
D (1+g)/E
(D0/E0)(1+g)
(1−b) (1+g)
∗ Justified trailing P0/E0 = 0 r − g 0 =
=
r−g
r−g
h. GGM strength & limitation
Strengths
Simple and applicable to stable, mature firms
Can be applied to entire markets
g can be estimated using macro data
Can be applied to firms that repurchase stock
Limitations
Not applicable to non-dividend-paying firms
g must be constant
Stock value is very sensitive to r – g
Most firms have nonconstant growth in dividends
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LOS 23 Discounted Dividend Valuation
i. Growth / transition / mature phase
Growth -3stage
Transition -2stage
Maturity -GGM
•ROE >r (Rapidly  earnings)
•ROE → r (Earnings growth slows)
•ROE = r
•Heavy reinvestment
•Capital reinvestment slows
•Earnings & dividends growth matures
•Small or no dividends
•FCFE & dividends 
•Gordon growth model useful
j. 2stage / H-model / 3Stage DDM
k. Terminal Value
▪ DCF(GGM) : TV10 =
▪ Multiple :
TV10 =
D11
r−g
P
× E10
E10
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LOS 23 Discounted Dividend Valuation
l. Calculate Value
H-Model :
V0 =
[D0 × (1+gL)]+[D0 × H(gS − gL)]
r −gL
m. Spreadsheet modeling
n. Required return using DDM
D
∗ r = P1 + g
0
D
∗ r = P0 [(1+gL)+H(gS − gL)] + gL
0
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LOS 23 Discounted Dividend Valuation
o. Sustainable growth rate
▪ g = b × ROE
ROE =(
Net Income
Sales
Sales
Total Asset
) × ( Total Asset) × ( Equity )
▪ PRAT model
g =(
Net Income −Dividends
Net Income
Sales
Total Asset
)×(
)×(
)×(
)
Net Income
Sales
Total Asset
Equity
p. Decision making
▪ Market price > Model(DDM) Price ➔ Overvalued
▪ Market price = Model(DDM) Price ➔ Fairly valued
▪ Market price < Model(DDM) Price ➔ Undervalued
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Study Session 10
LOS 20
LOS 21
LOS 22
LOS 23
Free Cash Flow Valuation
Market-Based Valuation
Residual Income Valuation
Private Company Valuation
LOS 24 Free Cash Flow Valuation
a. FCFF vs FCFE
Equity Value
= FCFF Discounted at
WACC – Debt Value
∞
∗Firm value = ෍
𝑡=1
Equity Value
= FCFE Discounted at
Required Equity Return
𝐹𝐶𝐹𝐹𝑡
1 + 𝑊𝐴𝐶𝐶
𝑡
∗Equity value = Firm value – MV of Debt
∞
∗Equity value = ෍
𝑡=1
𝐹𝐶𝐹𝐸𝑡
1+𝑟 𝑡
▪ If capital structure is stable, Use FCFE
▪ If negative FCFE or high/changing debt levels, Use FCFF
b. FCF - Ownership perspective
▪ FCF : Control perspective
▪ DDM : Minority owner
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LOS 24 Free Cash Flow Valuation
c. FCFF/FCFE formula
∗FCFF = 𝑁𝐼 + 𝑁𝐶𝐶 + 𝐼𝑛𝑡 1 − 𝑡 − 𝑊𝐶𝐼𝑛𝑣 − 𝐹𝐶𝐼𝑛𝑣
∗FCFE = FCFF − 𝐼𝑛𝑡 1 − 𝑡 + 𝑁𝑒𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠
⚫ NCC
Non Cash Items
Adjustment to NI
Dep & Amor
Add
Restructuring charge provisioning(reversal)
Add(Substract)
Gains(Losses) on Asset sale
Substract(Add)
Amortization of bond discount(premium)
Add(Substract)
Tax - DTL (DTA)
Add(Substract)
Note
Include Other non cash items – impairment…
Only unlikely to reverse
⚫ Int(1-t)
▪ Treat Preferred stock dividend just like interest exp, except Dp is not tax deductible
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LOS 24 Free Cash Flow Valuation
c. FCFF/FCFE formula
⚫ WC investment
▪ WC = operating asset – operating liabilities
▪ Exclued cash, interest bearing asset/lia
▪ Increase(decrease) in assets is an outflow of cash. Increase(decrease) in liabilities is a source of cash.
⚫ FC investment
▪ 고정자산매각 없을 경우 : FCI = CAPEX = ∆Gross PPE = ∆Net fixed asset(End net PPE – Beg net PPE) + dep
▪ 고정자산매각 있을 경우 : FCI = CAPEX – proceeds from assets sale = ∆Net fixed asset + dep – gain on sale(+loss on sale)
⚫ Net Borrowings
▪ Treat Preferred stock just like debt
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LOS 24 Free Cash Flow Valuation
c. FCFF/FCFE formula
∗FCFF = 𝑁𝐼 + 𝑁𝐶𝐶 + 𝐼𝑛𝑡 1 − 𝑡 − 𝑊𝐶𝐼𝑛𝑣 − 𝐹𝐶𝐼𝑛𝑣
= 𝐸𝐵𝐼𝑇 1 − 𝑡 + 𝑑𝑒𝑝 − 𝑊𝐶𝐼𝑛𝑣 − 𝐹𝐶𝐼𝑛𝑣
= 𝐸𝐵𝐼𝑇𝐷𝐴 1 − 𝑡 + 𝑡 ∙ 𝑑𝑒𝑝 − 𝑊𝐶𝐼𝑛𝑣 − 𝐹𝐶𝐼𝑛𝑣
= 𝐶𝐹𝑂 + 𝐼𝑛𝑡 1 − 𝑡 − 𝐹𝐶𝐼𝑛𝑣
∗FCFE = FCFF − 𝐼𝑛𝑡 1 − 𝑡 + 𝑁𝑒𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠
= 𝑁𝐼 + 𝑁𝐶𝐶 − 𝑊𝐶𝐼𝑛𝑣 − 𝐹𝐶𝐼𝑛𝑣 + 𝑁𝑒𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠
= 𝐶𝐹𝑂 − 𝐹𝐶𝐼𝑛𝑣 + 𝑁𝑒𝑡 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔𝑠
= 𝑁𝐼 − 1 − 𝐷𝑅 𝐹𝐶𝐼𝑛𝑣 − 𝑑𝑒𝑝 − 1 − 𝐷𝑅 𝑊𝐶𝐼𝑛𝑣
d. FCFF/FCFE calculation
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LOS 24 Free Cash Flow Valuation
e. Forecasting FCFF/FCFE
⚫ Historical FCF → calculate growth rate → apply growth rate : FCFn = FCF0(1+g)n
⚫ Forecast component of FCF : forecast each component of FCF – NI, WCI, FCI, NCC
⚫ Assuming constant capital structure
▪ Debt ratio = D/(D+E)
▪ FCFE = NI - (FCI -dep) – WCI + NB = NI – (1-DR)(FCI -dep) – (1-DR)WCI
f. NI → FCFE(control) → Div(minority)
g. Effect of financing decisions on FCF
⚫ Dividend : no effect on FCFF/FCFE
⚫ Share repurchase : no effect on FCFF/FCFE
⚫ Share issue : no effect on FCFF/FCFE
⚫ Leverage change : no effect on FCFF. But, minor effect on FCFE
▪ If debt → current year NB  → FCFE . Future NB  / int exp  → FCFE 
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LOS 24 Free Cash Flow Valuation
h. NI/EBITDA as proxies for FCFE/FCFF
⚫ NI is poor proxy for FCFE
⚫ EBITDA is poor proxy for FCFF
i. FCF models
⚫ Single stage FCF model
FCFF0(1+g)
FCFF1
∗Firm value0 = WACC−g
= WACC−g
,
∗Equity value0 =
FCFE1
r−g
=
Equity value = Firm value – MV of debt
FCFE0(1+g)
r−g
⚫ Multi-stage FCF model
▪ Base case : 2stage FCF with the GGM for terminal value
j. Estimate value using FCF model
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LOS 24 Free Cash Flow Valuation
k. Sensitivity analysis in FCFE/FCFF valuation
⚫ 2 major sources : growth, base year
l. Terminal value
⚫ GGM
∗Termanal valuen =
FCFEn+1
r−g
⚫ Multiple approach
𝑃
𝑃
∗Termanal valuen = 𝑡𝑟𝑎𝑖𝑙𝑖𝑛𝑔 𝐸 × EPSn, 𝑙𝑒𝑎𝑑𝑖𝑛𝑔 𝐸 × EPSn+1
m. Decision making
▪ Market price > Model(FCF Model) Price ➔ Overvalued
▪ Market price = Model(FCF Model) Price ➔ Fairly valued
▪ Market price < Model(FCF Model) Price ➔ Undervalued
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LOS 25 Market-Based Valuation
a. Method of comparables vs method of forecasted fundamentals
⚫ Method of comparables : actual P/E vs benchmark(peer group) P/E
⚫ Method of fundamentals : actual P/E vs justified P/E
▪ Actual price multiple(P/E…) > Benchmark multiple or Justified multiple ➔ Overvalued
▪ Actual price multiple(P/E…) = Benchmark multiple or Justified multiple ➔ Properly valued
▪ Actual price multiple(P/E…) < Benchmark multiple or Justified multiple ➔ Undervalued
b. Justified price multiple
⚫ Justified price multiple : What the price multiple should be if the stock is fairly valued
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LOS 25 Market-Based Valuation
c. Price multiple – rationales & drawbacks → d. calculate & interpret
Rationales
P/E
Drawbacks
-Earnings is primary determinant
-Earnings can be negative
-Popular
-Earning : volatile, non-recurring items 포함
-Empirical research
-Accounting method – management discretion
market price
∗Trailing P0/E0 = 𝐸𝑃𝑆 𝑙𝑎𝑠𝑡 12 𝑚𝑜𝑛𝑡ℎ𝑠,
market price
*Leading P0/E1 = 𝐹𝑜𝑟𝑒𝑐𝑎𝑠𝑡 𝐸𝑃𝑆 𝑛𝑒𝑥𝑡 12 𝑚𝑜𝑛𝑡ℎ𝑠
Rationales
-BV is generally positive
-BV is more stable than EPS
P/B
-Good for firms with Liquid assets(financial firm)
-청산회사 평가 시 유용
-Empirical research
Drawbacks
-Does not reflect value of intangible, off-BS assets
-Asset level/Business model 다른 회사간 비교 어려움
-BV와 MV 괴리 큰 기업간 비교 어려움
(Inflation, technological change 등에 기인)
-Different accounting conventions obscure comparability
(particularly international)
*BV = (TA–TL–PS)/# of shares
*Adjustment
▪ 1)Tangible BV, 2)Accounting method 조정, 3)off-BS 항목 고려, 4)BV와 MV 차이 조정
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LOS 25 Market-Based Valuation
c. Price multiple – rationales & drawbacks → d. calculate & interpret
Rationales
Drawbacks
-Sales is always positive
P/S
-Manipulation 가능성 
-Sales는 earnings, CF와 관련 
-Useful for mature, cyclical and start-up firm
-Cost structure 반영 X
-Sales are more stable than EPS
-Manipulation 가능성 낮지만 다소 존재
-Empirical research
-Manipulation 가능성 가장 낮음
P/CF
-Stable
-NI+dep+amor : noncash revenue와 WC변화 반영X
-회계 영향
-FCFE : 이론적으로 우수하나, volatile & (-) 가능성 
-Empirical research
D/P
-Dividend yield는 total return의 구성요소
-DY는 total return의 일부일 뿐
-DY가 capital appreciation 보다 risk 적은 항목
-현재 배당은 미래 이익의 희생(trade-off)
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LOS 25 Market-Based Valuation
e. Underlying earnings / Normalized earnings
⚫ Underlying earnings : non-recurring items 제거한 earnings
⚫ Normalized earnings : 경기변동(cyclical components) 영향 제거한 mid-cycle earnings – 2가지 방법
▪ Historical Avg.EPS : full business cycle 기간 동안의 평균 EPS
▪ Avg.ROE × current BVPS : full business cycle 기간 동안의 평균 ROE에 현재 BV 대응 – net assets size를 감안한 EPS
f. Earnings yield – E/P
⚫ High E/P is cheap, low E/P is expensive
g. Justified multiples ➔ h. calculate
⚫ Justified P/E
D1/E1
∗Leading P0/E1 = r −
g
∗Trailing P0/E0 =
=
D0(1+g)/E0
r−g
1−b
r−g
=
▪ r → P/E
(D0/E0)(1+g)
(1−b) (1+g)
=
r−g
r−g
▪ g → P/E
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LOS 25 Market-Based Valuation
g. Justified multiples ➔ h. calculate
⚫ Justified P/B
E1(1−b)
V=P =
r−g
B0 × ROE(1−b)
=
r−g
ROE(1−b)
, → 양변 ÷ B0 → P0/B0 =
r−g
ROE−ROE∗b
ROE−g
=
=
r−g
r−g
⚫ Justified P/S
[
P/CF =
𝐹𝐶𝐹𝐸0 × 1 + 𝑔
]
𝑟−𝑔
CF
▪ (ROE-r) → P/B
▪ P.M → P/S
E (1−b)(1+g)
(E /S )(1−b)(1+g)
V=P = 0 r − g
, → 양변 ÷ S0 → P0/S0 = 0 0 r − g
= profit margin×trailing P/E
⚫ Justified P/CF
▪ ROE → P/B
⚫ Justified D/P
⚫ Justified EV/EBITDA
[
EV/EBITDA =
𝐹𝐶𝐹𝐹0 × 1 + 𝑔
𝑊𝐴𝐶𝐶 − 𝑔 ]
EBITDA
▪ g → P/S
V=P =
D0(1+g)
1+g
r−g
, P0/D0 =
, → 역수 → D0/P0 =
r−g
r−g
1+g
▪ r → P/CF
▪ g → EV/EBITDA
▪ r → D/P
▪ g → P/CF
▪ FCFF → EV/EBITDA
▪ g → D/P
▪ WACC → EV/EBITDA 
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LOS 25 Market-Based Valuation
i. Predicted P/E
⚫ Peer그룹의 regression 분석을 통해 적정 P/E 추정
⚫ P/E 결정요소 : payout, volatility(β), growth
j. Valuaton using comparables & r. Decision making
⚫ Target P/E vs Benchmark P/E → watch the fundamentals!
⚫ IF “Target P/E < Benchmark P/E” → 3가지 가능성 : 1)undervalued, 2)Target g, 3)Target r
⚫ Fed model
▪ E/P < 10yr T-bond → overvalued
▪ E/P > 10yr T-bond → undervalued
⚫ Yardeni model
▪ CEY = CBY – k×LTEG + 𝜀𝑖,
where, CEY(current earnings yield), CBY(A rated corp bond yield), k 𝑤𝑒𝑖𝑔ℎ𝑡𝑖𝑛𝑔 𝑓𝑎𝑐𝑡𝑜𝑟 , LTEG(5yr earnings growth rate)
∗P/E =
1
CBY−k × LTEG
▪ r → P/E
▪ g → P/E
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LOS 25 Market-Based Valuation
k. PEG ratio
∗PEG 𝑟𝑎𝑡𝑖𝑜 =
P/E
growth rate
l. Terminal value
𝑃
𝑃
× EPSn, T𝑉n = 𝐽𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑
× EPSn+1
𝐸𝑛
𝐸𝑛 + 1
⚫ Fundamental approach
∗T𝑉n = 𝐽𝑢𝑠𝑡𝑖𝑓𝑖𝑒𝑑
⚫ Comparable approach
∗T𝑉n = 𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘
𝑃
𝑃
× EPSn, T𝑉n = 𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘
× EPSn+1
𝐸𝑛
𝐸𝑛 + 1
m. Types of cashflow
⚫ NI + dep + amor
⚫ Adjusted CFO
⚫ FCFE = CFO – FCinv + NB
⚫ EBITDA = EBIT + dep + amor
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LOS 25 Market-Based Valuation
n. EV/EBITDA
⚫ EV = MV of (common stock + preferred stock + debt ) + minority interest – cash/Investment
⚫ EBITDA is an earnings flow to both debt and equity holders
⚫ EV/EBITDA ratio provide an indication of total company value, not equity value
Rationales
-Leverage 다른 회사간 비교에 적합(EBITDA is pre-interest)
-Capital intensive business valuation에 적합(control for
dep/amor differences)
-EBITDA is usually positive when EPS is negative
Drawbacks
-Ignore changes in WC investment
-Ignore changes in FC investment → FCFF is more closely
linked with valuation theory
⚫ Alternatives
▪ EV ≈ TIC(= MV of “debt+equity”)
▪ EBITDA ≈ EBIT / Sales / FCFF
o. International Considerations
⚫ In an international context, using relative valuation based on comps is challenging due to differences in “accounting
mehod, cultures, risk, and growth opportunities”
⚫ 다른 국가간 기업 비교 시 P/adjusted CFO, P/FCFF 는 상대적으로 회계기준 영향 , 반면 P/E, P/B 등은 영향
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LOS 25 Market-Based Valuation
p. Momentum indicators
⚫ Unexpected earnings(earnings surprise) = reported EPS – expected EPS
⚫ Standardized Unexpected earnings(SUE) = surprise/𝜎(surprise)
⚫ Relative strength indicators
q. Measures of central tendency
⚫ Arithmetic mean - outlier 영향
⚫ Harmonic mean - small value 영향
⚫ Weighed harmonic mean - 가장 ideal
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LOS 26 Residual Income Valuation
a. Residual income, EVA/MVA
⚫ RI = NI - $r(cost of equity) = 𝐵𝑉t−1 ×
▪ ROE>r → +RI → V>BV
𝑁𝐼
−𝐵𝑉t−1
𝐵𝑉t−1
×r = 𝐵𝑉t−1 × (𝑅𝑂𝐸 −r)
▪ ROE=r → RI=0 → V=BV
▪ ROE<r → -RI → V<BV
⚫ EVA = NOPAT - (WACC×IC) = EBIT(1-t) - $WACC
⚫ MVA = MV of firm – BV of firm
b. Use of RIM
⚫ Managerial effective 측정
⚫ Goodwill impairment 평가
⚫ Equity valuation
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LOS 26 Residual Income Valuation
c. Calculate value
⚫ RI = 𝐸t − (𝑟 × 𝐵t−1) = 𝐵t−1 × (𝑅𝑂𝐸 −r)
⚫ Clean surplus relationship :
𝐵t = 𝐵t−1 + Et − 𝐷t
⚫ RI approach : Value = BV + PV of all future RI → 주주자본비용 지급 후의 “순액“ 개념(주주자본비용 해당분이 BV0)
⚫ B0 represents a large portions of value, RIM is less sensitive to TV
𝑅𝐼1
𝑅𝐼2
∗Value = 𝐵0 +
+
1+𝑟
1+𝑟
∞
∞
𝑹𝑰𝒕
+ ⋯ = 𝑩𝟎 + ෍
2
𝟏+𝒓
𝒕=𝟏
𝒕
𝐹𝐶𝐹𝐸1 𝑜𝑟 𝐷𝑖𝑣1 𝐹𝐶𝐹𝐸2 𝑜𝑟 𝐷𝑖𝑣2
𝐹𝐶𝐹𝐸𝑡 𝑜𝑟 𝐷𝑖𝑣𝑡
∗Value =
+
+⋯ =෍
2
1+𝑟
1+𝑟
𝟏+𝒓 𝒕
𝑛
=෍
𝑡=1
𝒕=𝟏
𝐹𝐶𝐹𝐸𝑛 𝑜𝑟 𝐷𝑖𝑣𝑛
+ 𝑇𝑉
1+𝑟 𝑛
d. Fundamental determinants of RI
⚫ Single stage RIM
∗V = 𝐵0 +
𝑅𝑂𝐸 − 𝑟 × 𝐵0
𝑅𝐼1
= 𝐵0 +
𝑟−𝑔
𝑟−𝑔
⚫ Tobin’s Q =
𝑀𝑉 0𝑓 (𝑑𝑒𝑏𝑡 + 𝑒𝑞𝑢𝑖𝑡𝑦)
𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
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LOS 26 Residual Income Valuation
e. RIM & Justified P/B
Justified P/B =
ROE−g
r−g
→ 분자에 + 𝑟 − 𝑟 → P/B = 1 +
ROE−r
r−g
V=P = B0 +
B0 × (ROE−𝑟)
r−g
f. Calculate value using RIM
g. Implied growth rate
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LOS 26 Residual Income Valuation
h. Continuing RI
⚫ Single stage RIM
∗V = 𝐵0 +
𝑅𝑂𝐸 − 𝑟 × 𝐵0
𝑅𝐼1
= 𝐵0 +
𝑟−𝑔
𝑟−𝑔
𝑇−1
⚫ Multi stage RIM : V = B0 + PV of high growth RI + PV of CRI(TV)
∗V = 𝐵0 + ෍
𝑡=1
𝑅𝐼𝑡
𝑅𝐼𝑇
+
𝑡
1+𝑟
1+𝑟−𝜔 1+𝑟
𝑇_ 1
⚫ Persistence factor 𝜔 (0≤ 𝜔 ≤ 1)
▪ Higher 𝜔 factors : 1)low dividend payout(RR →g →𝜔), 2)high RI persistence industry
▪ Lower 𝜔 factors : 1)high ROE, 2)large nonrecurring items, 3)high accruals
⚫ CRI assumptions
Current level forever(𝜔=1)
𝐶𝑅𝐼𝑇 − 1 =
Drop to zero(𝜔=0)
𝐶𝑅𝐼𝑇 − 1 =
Decline over time to zero(0<𝜔 < 1)
𝐶𝑅𝐼𝑇 − 1 =
𝑅𝐼𝑇
𝑟
𝑅𝐼𝑇
1+𝑟
𝑅𝐼𝑇
1+𝑟−𝜔
Decline to a long-run level
𝐶𝑅𝐼𝑇 − 1 =
𝑅𝐼𝑇 + (𝑃𝑇 − 𝐵𝑇)
,
1+𝑟
𝑃𝑇 = P/B𝑇 × 𝐵𝑇
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LOS 26 Residual Income Valuation
i. RIM vs FCF/DDM
j. Strengths & weaknesses
⚫ Strengths
▪ Terminal value does not dominate intrinsic value
▪ Accounting data usually easy to find
▪ Applicable even when cash flows are volatile or without “Div / positive FCF”
▪ Focus on economic profitability
⚫ Weaknesses
▪ Accounting data can be manipulated
▪ Reliance on accounting data requires many adjustments
▪ Assumes clean surplus relation holds
k. Accounting Issues
⚫ Clean surplus violations
⚫ Off BS items
⚫ Intangible assets
⚫ Nonrecurring items & aggressive accounting practices
⚫ International considerations
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LOS 26 Residual Income Valuation
k. Accounting Issues
⚫ Clean surplus violations(OCI items) – BV is correct, NI is not correct
▪ F/X translation gain/loss
▪ Minimum pension liabilities
▪ Unrealized gain/loss for AFS
▪ Deferred gain/loss on cash flow hedges
▪ Revaluation of PP&E
⚫ Off BS items
▪ Operating lease → capitalize
▪ Off-BS SPEs → consolidate
▪ LIFO→FIFO
▪ DTA/DTL → eliminate(only if not expected to reverse)
⚫ Intangible assets
▪ Intangible(goodwill) → capitalize. Amortization should be removed prior to computing ROE
▪ R&D cost → capitalize(only if productive)
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LOS 26 Residual Income Valuation
k. Accounting Issues
⚫ Nonrecurring items & aggressive accounting practices
▪ Discontinued operation, Accounting changes, Restructuring charges, Unusual & extraordinary items → RI 계산 시 제외
▪ Aggressive한 회계처리 조정
⚫ International considerations
▪ Reliable earnings forecast?
▪ Clean surplus relationship?
▪ Poor earnings quality?
l. Decision making
▪ Market price > Model(RIM) Price ➔ Overvalued
▪ Market price = Model(RIM) Price ➔ Fairly valued
▪ Market price < Model(RIM) Price ➔ Undervalued
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LOS 27 Private Company Valuation
a. Public vs Private
Company-Specific Differences
Private Firms
Public Firms
Life Cycle Stage
Less mature
Later in life cycle
Size
Smaller size →  risk →  risk premiums
Larger and have access to public financing
Ownership Overlap
Managers often have substantial ownership
position
Greater external shareholder ownership
Short Term Investor
Long term perspective
Short term View
Quality of Financial Statement
Lower quality of information disclosure
→ risk  & valuations 
 pressure to make timely, detailed
disclosures
Tax Concern
High
Low
Quality & depth of management
Potentially  quality & depth of
management
Greater quality & depth of management
Stock-Specific Differences
Private Firms
Public Firms
Liquidity
Shares are less liquid → liquidity discount
Greater number of shareholders
Concentration of control
Concentration of control
Share ownership and control are more diffuse
Restriction on marketability
Potential restrictions on sale of shares
Public market for shares
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LOS 27 Private Company Valuation
b. Reasons for Private Equity Valuations
Transaction Related
Private financing
IPOs
Compliance Related
Financial reporting
Acquisitions
Bankruptcy
Share-based Compensation
Litigation Related
Damages
Lost profits
Tax Purpose
Shareholder disputes
c. Private Company Valuation
Income Approach
•DCF : Present value of expected future cash flows or income
Market Approach
•Multiples : Relative valuation
Asset-Based Approach
•Assets minus liabilities
▪ Non-operating asset : valuation에 포함
▪ Firm size : Small 비상장사 평가 시 Large cap multiple 사용은 부적절
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LOS 27 Private Company Valuation
d. Cash flow estimation issues
⚫ Normalized Earnings = Reported Earnings + Adjustments(For nonrecurring, unusual items)
▪ Discretionary/tax-motivaed expense : Compensation expense, Personal expense, Use of company asset
▪ Real estate : 부동산 nonoperating asset으로 처리, 감가상각 대신 rental expense로 조정, 특수관계인으로부터 리스료는 시가로 조정
▪ Others : 회계처리 방법의 차이 조정. 감사(audit) vs 검토(review)
⚫ Strategic buyer(Synergy 고려) vs Non-strategic buyer
⚫
▪
▪
▪
▪
Estimating Cash flow
Cash flow의 불확실성 높다면 → scenario 분석
지배주주 vs 소액주주 : 각각 다른 cash flow 추정
Management 추정 vs Analyst 추정 : management의 과다추정 가능성
FCFF vs FCFE : FCFF는 재무구조 변화 많을 때 적절(WACC가 r 보다 leverage 변화에 덜 민감)
e. Income Approach: Three Method
1. Free Cash Flow method : 2stage FCF
2. Capitalized Cash Flow method : single stage FCF
3. Excess earnings(Residual Income) method
•Based on an estimate of the value of intangible assets, working capital, and fixed assets
•Intangible asset value : 1)Excess earnings=[earnings-$r on (WC+FC)] → 2)Capitalize
•Firm Value = Tangible(value of WC/FC) + Intangible(PV of future excess earning)
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LOS 27 Private Company Valuation
f. Discount Rate adjustment
⚫ Size Premiums : small size → cost 
⚫ Higher Cost Debt : Limited availability / Higher operating risk → increased cost of debt
⚫ Discount Rates in an Acquisition Context : Should be consistent with cash flows, not buyer’s “lower” cost of capital
⚫ Projection Risk : 추정오류의 가능성(information availability , less experienced manager)→ cost 
⚫ Life Cycle stage : early stage, unsystematic(company-specific) risk  → CAPM 적절치 않음
g. Required Rate of Return Models
CAPM-Private에 사용 어려움
Expanded CAPM
Build-Up Approach
Rf
Rf
Rf
Βi×(equity risk premium)
Βi×(equity risk premium)
equity risk premium
Size(Small stock) premium
Size(Small stock) premium
Company-specific risk premium
Company-specific risk premium
Industry risk premium
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LOS 27 Private Company Valuation
h. Market Approach: Three Methods
⚫ Large private firm : EBIT or EBITDA multiple
ex> MVIC/EBITDA
⚫ Small private firm : NI multiple ex>P/E (자산규모 작아 EV multiple 실익 )
⚫ Extremely small private firm : Revenue multiple
ex>P/S (아주 작은 회사는 이익 X, 비용도 경영자 discretion)
GPCM(Guideline Public Company)
•상장사 date – 기본적으로 minority 입장→Control Premium이 포함 X
•Control Premium 관련 고려사항 : Strategic vs financial, Cash vs Stock, Industry condition, Reasonableness
GTM(Guideline Transactions)
•최근 M&A data - Based on pricing multiples from the sale of entire companies → Control Premium이 포함
•Control Premium 관련 고려사항 : Strategic vs financial, Cash vs Stock, Contingent consideration, data
availability, date of data
PTM(Prior Transaction Method)
•해당 회사 스스로의 과거 거래 data – 소액주주 평가 시 적합
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LOS 27 Private Company Valuation
i. Asset based Approach
⚫ The value of ownership is equivalent to the fair value of its assets less the fair value of its liabilities
⚫ Rarely Used for Going Concerns : Difficulty in valuing intangible assets
⚫ Most Appropriate for
▪ Resource firms
▪ Financial services firms, Investment companies (real estate investment trusts, closed-end investment companies)
▪ Small businesses with limited intangible assets or early stage companies
j. Valuation Discounts/Premiums – Control / Marketability
Lack of Control Discount (DLOC)
Lack of Marketability Discount (DLOM)
Total Discount
•DLOC = 1 – [1/(1 + Control premium)]
•Pre IPO price/Post IPO price 등의 대안 → 실행 어려움
•Total discount= 1-[(1-DLOC)(1-DLOM)]
⚫ GTM – typically Control → Minority 평가 시 Discount
⚫ GPCM - typically Minority → Control 평가 시 Premium
⚫ FCF/CCM – control/minority → depends on “cash flow”
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