Dividend Discount Model

=1
=2
=
=0 =
+
+
,
(1 + ) (1 + )2
(1 + )
= ,
Residual Income Model
=1
=2
=
=0 = =0 +
+
+
(1 + ) (1 + )2
(1 + )
, = + ( ) +

Perpetuity: =0 = , ,

Growing Perpetuity: =0 =
Two Step Approach: =0 =

=1 (1+)

+ ()(1+)

Calculate total dividends (d), net income (NI), residual income (RI), payout ratio,
future book value, total shares outstanding, ROE.
= 1 +
OR: = 1 ( )
= 1
=

OR =

= 1
OR: = 1 (

OR: = 1 ( )
= + 1
Reformulated Statement of Shareholders Equity Notes
Step 1: restate beginning and ending balances of common equity
Look for preferred stock (which should be taken out), and dividends payable
(which should be added back in).
Dividends Payable can be found in the Accrued Liabilities Note.
Dividend Reported is on Statement of Equity
Step 2: Calculate net transactions with shareholders
Cash Dividend Paid = Dividends Reported Dividends Payable
Determine all contributions and distributions of equity with shareholders
Step 3: Calculate True Net Income
= + , such as preferred dividends
= ( )
Included in OCI are:
o
Unrealized gains/losses on available-for-sale securities
o
Foreign currency translation gains/losses
o
Unrealized gains/losses on hedge instruments/derivatives
Reformulated Statement of Shareholders Equity Example:
Beginning Balance:
Transactions with Shareholders=
Shareholder Contributions (+)
Stock Repurchases (-)
Cash Dividends Paid (-)
Total
Comprehensive Income=
Reported Net Income
OCI
Other income/expenses
Total
Ending Balance (=BB + Transactions + Comprehensive Income)
Reformulated Balance Sheet Notes
Operating Asset/Liability or Financing Obligation?
Cash: operating cash vs extra cash
Short-term notes receivable: depends
Short-term investments: financing
Short-term notes payable: depends
Accrued Expenses: operating, EXCEPT interest payable
Lease assets: operating
Lease liabilities: financial
Deferred tax assets or liabilities: operating
Dividends payable: none (part of equity)
Hedges/derivatives: depends on what is being hedged, e.g. if hedging interest
rates, then financing, if hedging currency, then operating
Preferred stock: financing
Minority interest: not financing, separate section

Understand the two key assumptions of the usefulness of FSA and how they affect the
success of fundamental analysis
The two key assumptions of FSA are:
1. Assume the usefulness of accounting numbers
a.
accounting information is useful for evaluating key value drivers
and thus for estimating firm value
2. Markets are relatively efficient
a.
Stock prices can sometimes deviate, but will eventually converge
to the intrinsic value of the firm over the long run
Reformulated Balance Sheet Example:
Operating Assets:
Operating cash
A/R
Inv
Deferred Income Taxes
Prepaid Expenses and other current assets
PP&E
Intangible Assets
Goodwill
Deferred Income Taxes and Other Liabilities
Total
Operating Liabilities:
A/P
Accrued Liabilities
Income Taxes Payable
Deferred Income Taxes and Other Liabilities
Liabilities of Discontinued Ops
Total
Net Operating Assets (Operating Assets Operating Liabilities):
Net Financing Obligations: (be careful of signs)
Extra cash
Short-term investments
Derivatives on financing things (interest rate swaps, etc)
Current portion of long-term debt
Notes payable
Long-term debt
Preferred Stock
Total
Common Stockholders Equity (= Net Operating Assets Net Financing
Obligations):
Book Income:
Book Income is simply the income reported on the Income Statement.
Deferred and Current Components of Tax Expenses
The deferred and current components of the tax expenses should be in a Note.
Effective Tax Rate
The Effective Tax Rate can be found in a Note, and is the tax rate that incorporates all
tax rates the company has to deal with.
Marginal Tax Rate
The marginal tax rate is the highest rate that income is taxed at. For example, if the US
tax rate is 37% and the effective tax rate is 25%, you would use the US tax rate as your
marginal tax rate.
Understand the drivers of dividends and free cash flows.
= ( ) = , ( )
=
Basic Framework of Fundamental Analysis
Step 1: Understand the Past
Understand the business, the industrys economics, and the firms strategy
Clean up the accounting data (reformulating financial statements)
Analyze data (focus on the key drivers of value)
Step 2: Forecast the Future Performance of the Firm
Step 3: Valuation
Estimate the firms value
Make investment decisions
Understand how including preferred stock in common equity and classifying dividend
payable as a liability rather than as an equity affects the valuation of common equity.
To common shareholders, preferred equity is essentially a financial liability, as it is
an obligation to pay other claimants before themselves. So it shouldnt be
included in common equity.
Dividends payable is reported as a liability, but how can shareholders owe
dividends to themselves? In essence, dividends payable are part of equity that
common shareholders have in the company. Basically, they own it, but just
havent paid it to themselves yet. So it should be included in common equity.

Reformulated Income Statement Notes

Typically included in Financial Income/Expenses:
Interest income/expenses
Gains/losses on financial assets
Gains/losses on debt retirement or extraordinary items
Gains/losses on redemption of preferred stock
Preferred dividends
Splitting Tax into operations and financing:
Step 1: calculate tax benefit/expense for net financial position
Tax benefit/expense = Net Financial Position * Marginal Tax Rate
Step 2: Estimate tax on Operating Income
Tax on Operating Income = Reported Taxes + Tax expense/benefit
Reformulated Income Statement Example:
Net Sales
- COGS
- SGA, R&D, any other expenses that generate sales
= Operating Income Before Tax
-Reported Tax
- Tax benefit/expense from net financial position
- tax allocated to other operating income
= Operating Income After Tax
+/- other operating incomes or expenses requiring tax allocation
- tax on other operating incomes
+/- After tax Operating Items
= Final Operating Income
Net Financial Expenses (After-Tax):
Interest Expense
- Interest Income
= Net Interest Position Before Tax
+ Tax Benefit from net interest expenses
= Net interest expenses after tax
+/- Gains/losses on debt retirement
+/- realized gains/losses on financial assets
+ preferred dividends
+/- gains/losses on redemption of preferred stock
Total:
-Minority Interest
= Net Income to Common Stockholders
Understand the relationship between ROE and the steady state.
A company is in the steady state when its ROE is constant, meaning that Net Income
and Book Value grow at the same constant rates. This growth rate is called the
sustainable growth rate.
Capitalizing Operating Leases
Given a Note containing a table of capital leases and operating leases, you have to
determine the PV of the future operating lease payments. For your discount rate, you
have to either back out the interest rate on capital leases or if that is not available, use
the weighted average interest rate on the companys long term debt.
Example:
2012
2013
2014
2015
2016
thereafter

Capital Leases
228
221
207
187
173
836

Operating Leases
2910
2595
2437
2038
1707
8129

8129/1707 -> roughly 5. Then divide 8129/5 -> 1626 per year for the next five years
(2017, 2018, 2019, 2020, 2021). Discount these as well in your PV calculation.

Pros and cons of the dividend discount model and the residual income model
Advantages of RI over DDM:
Value Drivers: focus on value drivers the key of analyzing and forecasting
firm value the extra value created a higher return on equity (ROE) than the
cost of equity
Framework of analysis: provides a framework for analysts to further track
down value drivers to detailed business activities
Incorporation of financial statements: build on the value already recognized
in the balance sheet (the book value)
Validation: forecasts of residual earnings can be validated in subsequent
audited financial statements (dividends are arbitrary and not audited).
Versatility: the model can be used with a wide variety of accounting
principles
Disadvantages of RI compared to DDM:
Accounting complexity: requires an understanding of how accrual accounting
works
Accounting quality and manipulation: relies on accounting numbers than can
be of low quality and can be manipulated by management.
Understand the drivers of ROE and growth within the DuPont Model.
Basic DuPont Model:

PM
Advanced DuPont Model:

=

ATO

FLEV

PM
ATO
FLEV
Where Spread = (Return on Net Operating Assets Net Borrowing Costs)
Where PM = Profit Margin, ATO = Asset Turnover, FLEV = Financial Leverage
Understand how the value is created in business activities
This is done by splitting up business activities into operating and financial activities.
Operations are the source of long-term value creation for almost all companies.
Step 1: Fund the business (done through financial activities)
Step 2: Purchase assets needed for operations
Step 3: Generate Income from operations
How this process is revealed by reformulated financial statements
GAAP financial statements do not reflect the nature of different business activities and
may not be ready for analysis. Reformulation is not merely a rearrangement of numbers
on the financial statements, but also changes numbers to reflect the underlying
economics, and brings more details into the statements from the notes.
Understand how the off-balance-sheet assets/financing affects financial statements,
key ratios and valuation.
Keeping off-balance-sheet assets/financing off the balance sheet makes the company
look more efficient and less levered. (Asset Turnover, Current Ratio, and Leverage
Ratios)