University of New South Wales

Semester 1 2018
Weeks 1-4
Fundamental Analysis

Pedro Barroso

1
 Introduction to fundamental
analysis
Damodaran Ch. 2

2
Fundamental Analysis
 Fundamental analysis tries to estimate the intrinsic value
of the company.
 Uses discounted cash flow approach
 Relies heavily on accounting information to get necessary inputs.
 Also includes relative valuation (P/E, P/B) and contingent claims
analysis (real options, patents).

3
Discounted Cash Flows (DCF) Review

t n
CFt
Value  
 1 r 
t
t 1

 CFt is cash flow in period t, r is the appropriate discount

rate given the riskiness of the cash flows, and n is the life
of the asset.
 Value – may refer to the value of the entire business (debt +
equity) or just the value of equity (or debt)

4
Firm Valuation (Debt + Equity)
 The estimate of the value of the firm is obtained by discounting
expected cash flows to the firm:
 the cash flows after meeting all operating expenses, taxes, and
investments but prior to net interest expenses
 We use the weighted average cost of capital, which is the cost of the
different components of financing used by the firm, weighted by their
market value proportions (or capital structure ratios if available).

t n CFt to Firm
Value of Firm  
 1  WACC 
t
t 1

5
Equity Valuation
 The value of equity is obtained by discounting expected cash
flows to equity:
 the residual cash flows after meeting all expenses, tax obligations,
interest, and principal payments
 We use the cost of equity, i.e., the rate of return required by equity
investors in the firm.
t=n
CFt to Equity
Value of Equity= 
t=1 (1+k e ) t

where,
CFt to Equity = Expected Cash flow to Equity in period t
ke = Cost of Equity (we will often use ‘r’ as cost of equity).

6
Concept Check: Valuing Equity and Debt

 Consider a company with stable cash flows in perpetuity and constant capital
structure:
 The annual cash flow to the firm is 150.
 The firm has debt of 600 with an interest rate of 10%.
 The marginal tax rate is 50%.
 The cost of equity is 15%.
 The market value of equity is 800.

 What is the intrinsic value of equity?

 What is the intrinsic value of the firm?

7
Concept Check Solution: Equity and Firm
Valuation

 Equity: Discount CF to Equity at Cost of Equity to get value of equity

 Costof Equity = 15%
 PV of Equity = (150-10%x(1-50%)x600)/15% = $800

 Firm: Discount CF to Firm at Cost of Capital (WACC) to get value of firm

 Costof Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
 WACC = 15% (800/1400) + 5% (600/1400) = 10.71%
 PV of Firm = 150/0.10714 = $1400

 Note: Equity (through CF to firm):

 PV of Equity= PV of Firm – Debt = 1400 – 600= 800

8
First Principle of Valuation
 Always match cash flows and discount rates.
 Discounting cash flows to equity at the weighted average cost
of capital will lead to an upwardly biased estimate of the value
of equity

 Discounting cash flows to the firm at the cost of equity will

yield a downward biased estimate of the value of the firm.

9
The Effects of Mismatching Cash Flows and
Discount Rates

 Error 1: Discount CF to Equity at Cost of Capital to get equity

value
 PV of Equity = 120/.1071 = $1120
 Value of equity is overstated by $320.

 Error 2: Discount CF to Firm at Cost of Equity to get firm

value
 PV of Firm = 150 / 0.15= $1000
 PV of Equity = $1000 - $600 = $400
 Value of Equity is understated by $400, half the real value.

10
Discounted Cash Flow Valuation: The Steps
 Estimate the discount rate or rates to use in the valuation
 Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing
the firm)
 Discount rate can be in nominal terms or real terms, depending upon whether the cash flows are
nominal or real (always match these too!)
 Discount rate can vary across time.

 Estimatethe current earnings and cash flows on the asset, to either equity
investors (CF to Equity) or to all claimholders (CF to Firm)

 Estimatethe future earnings and cash flows on the firm being valued, by
estimating an expected growth rate in earnings.

 Estimatewhen the firm will reach “stable growth” and what characteristics
(risk & cash flow) it will have when it does.

 Choose the right DCF model for this asset and value it.

11
Step 1: Estimate the Discount Rate
 Damadoran Ch. 7 & 8 provides detailed discussion of
estimating the discount rate.

 For this class, we will focus on valuing equity, and thus are
most interested in the cost of equity (ke or r)
 We will assume r can be estimated using the CAPM.
 E(ri) = rf + Bi*E[rm-rf]
 rf can be estimated as the return on treasury bills
 rm-rf can be based on historical data (roughly 4-5%)
 Bi can be estimated from a time-series regression of stock returns on market
returns.
 You could also estimate cost of equity using alternative asset
pricing models (e.g. Fama and French 3 factor model).

12
Step 2: Estimating Cash Flows
 Estimating cash flows usually begins with a measure of
earnings.
 Earnings are available in a firm’s financial statements but there
are many nuances involved in understanding accounting
earnings.
 We will discuss some nuances (ex: R&D expenses) and how
they influence cash flows

13
 Overview of financial statements

Damodaran Ch. 3

14
Overview of financial Statements
 There are three basic accounting statements:
1) Balance Sheet – summarizes the assets owned by a firm, the
value of the assets, and the mix of financing.
Example: http://au.finance.yahoo.com/q/bs?s=RIO.AX&annual
Assets Liabilities and Owners
Equity
Fixed Assets Liabilities
Current Assets Current Liabilities
Financial Investments Debt
Intangible Assets Other Liabilities
Owners Equity
Equity
Total Assets Total Liabilities + Equity

15
Measuring Assets
 Fixed Assets – priced at historical cost adjusted for depreciation
 Examples: Plant, Equipment, Land, & Buildings

 Current Assets – fairly easy to price

 Examples: accounts receivable, cash, inventory

 Financial Investments – valuation depends on type (liquidity).

 Intangible Assets- costs typically expensed over the period in

which they occur (often treated as an expense, not a balance sheet
item)
 Examples: Patents, Trademark, R&D

16
Measuring the Financing Mix
 Current Liabilities – obligations that the firm has coming due in the next year
 Examples: Accounts Payable, Short-term borrowing, short-term portion of long-term
borrowing

 Long term Debt

 Examples: long term loans from a bank or long-term bond issued in the financial market

 Other Long term liabilities

 Examples: Leases, Pension Plans, Other Employee Benefits

 Owner’s Equity –
 Example: common equity, preferred stock, retained earnings

 Both equity and liabilities are typically valued using historical measures (i.e.
Book value)
17
Overview of Financial Statements
2) Statement of Cash Flows – specifies the sources and uses of
cash to the firm from operating, investing, and financing
activities during a year.
Example: http://au.finance.yahoo.com/q/cf?s=RIO.AX&annual
Cash flow from Operating Activities
Cash Receipt from Customers 9,500
Cash Paid to Suppliers (2000)
Cash from Operations 7500
Interest & Taxes Paid (5000)
Net Cash from Operations 2500
Cash Flows from Investing
Proceeds from Sale of Equipment 7500
Net Cash flow from Investing 7500
Cash flow from Financing
Dividends Paid (2500)
Net Cash flow from Financing (2500)
Net Increase in Cash & Cash Equivalents
18 7500
Overview of Financial Statements
3) Income Statement - information on the revenue and
expenses of a firm and the resulting income made by a firm
in a period.
Example: http://au.finance.yahoo.com/q/is?s=RIO.AX&annual

Revenue 3000
Operating Expenses (1000)
Operating Income (or EBIT) 2000
Financing Expenses (Interest) 500
Taxes (33.33%) 500
Net Income 1000

19
Accounting Measures of Profitability

Often important to gauge the profitability of firms as a percentage. Let

t = tax rate, BV = Book Value, i = interest rate, D= debt, and E = equity. Then:

 Return on Capital (ROC) = EBIT * (1-t)/BV Assets or

 ROC = [Net Income + Int * (1-t)]/ BV Assets
 ROC (intentionally) ignores tax benefit of debt.
 In this definition we typically exclude excessive cash of the BV of assets.

 Return on Equity(ROE) = Net Income/BV Equity or

 ROE = ROC + D/E[ROC – i(1-t)] (again excluding excessive cash)

 Useful links with data on RoE :

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/Inv2ed.htm
20
Steps in Cash Flow Estimation
 Start with earnings. Estimate the current earnings of the firm:
 If looking at cash flows to equity, look at earnings after interest
expenses - net income
 If looking at cash flows to the firm, look at operating earnings after
taxes – EBIT(1-t)
 Adjust earnings to undo certain accounting practices.

 Consider how much the firm invested to create future growth.

 If looking at cash flows to equity we must also consider the

cash flows from net debt issues (debt issued - debt repaid).

21
 Measuring Earnings

Damodaran Ch. 9

22
Estimate the current earnings of the firm

 Value of equity is discounted future cash flows to equity

holders.
 Estimation of future cash flows starts with earnings.
 However earnings ≠ free cash flows to equity

 The income statement reports earnings (i.e. Net Income)

 There are some potential problems with the reported accounting
earnings.
 Incorrectly classified operating expenses
 Capital Expenditures should not be classified as operating expense
 Financial Expenditures should not be classified as operating expenses
(example: leases)
 One-time (extraordinary) events

23
Types of Expenditures

 Operating expenditures – expenses that generate benefits for a firm in the

current period
 Wages
 Raw materials used in production
 Office expenses

 Capital expenditures – expenditures that generate benefits for the firm in

the future.
 Purchasing new land to expand business
 Upgrade to a new computer system

 Financing expenditures – expenditures associated with non-equity

financing
 Interest payments on debt
24
Incorrectly classified operating expenses
 Financial and capital expenses should not be included in
operating expenses.

 This is commonly violated. Examples:

 R&D is really a capital expense but treated as an operating expense
 Operating leases are really a financing expense but treated as an
operating expense.

 When looking at accounting earnings we need to adjust for

these ‘mistakes’.
 Note: these mistakes not only affect net income, but also book values
of assets.
 Important for profitability measures.
25
R&D Expenses: Operating or Capital
Expenses
 Accounting standards require us to consider R&D as an
operating expense even though it is designed to
generate future growth. It is more logical to treat it as
capital expenditures.

 To capitalize R&D,
 Specify an amortizable life for R&D (2 - 10 years)
 For how many periods does the research generate ‘considerable’ income.
 Collect past R&D expenses going back at least as long as the
amortizable life
 Sum up the unamortized R&D over the period.

26
Capitalizing R&D Expenses: Cisco in 1999
 Example: assume a 5-year life for R & D.
Year R&D Expense Unamortized portion Amortization this year
1999 (current) 1594.00 1.00 1594.00
1998 1026.00 0.80 820.80 $205.20
1997 698.00 0.60 418.80 $139.60
1996 399.00 0.40 159.60 $79.80
1995 211.00 0.20 42.20 $42.20
1994 89.00 0.00 0.00 $17.80
Total $ 3,035.40 $ 484.60
Value of research asset = $ 3,035.4 million
Amortization of research asset in 1999 = $ 484.6 million
Adjustment to Operating Income = $ 1,594 million - 484.6 million = 1,109.4 million
(same adjustment for net income and capital expenditures)

27
The Effect of Capitalizing R&D
Conventional Accounting R&D treated as capital expenditure
Income Statement Income Statement
EBIT& R&D = 5,049 EBIT& R&D = 5,049
- R&D = 1,594 - Amort: R&D = 485
EBIT = 3,455 EBIT = 4,564 (Increase of 1,109)
EBIT (1-t) = 2,246 (t=35%) EBIT (1-t) = 2,967
Ignored tax benefit = (1594-485)(.35) = 388
Adjusted EBIT (1-t) = 2967 + 388 = 3354
(Increase of $1,109 million)
Net Income will also increase by $1,109 million
Balance Sheet Balance Sheet
Off balance sheet asset. Book value of equity at Asset Liability
$11,722 million is understated because biggest R&D Asset 3035 Book Equity +3035
asset is off the books. Total Book Equity = 11722+3035 = 14757
Capital Expenditures Capital Expenditures
Conventional net cap ex of $98 million Net Cap ex = 98 + 1594 – 485 = 1206
Cash Flows Cash Flows
EBIT (1-t) = 2246 Adjusted EBIT (1-t) = 3354
- Net Cap Ex = 98 - Net Cap Ex = 1206
FCFF = 2148 FCFF = 2148
Return on capital = 2246/11722 (no debt) Return on capital = 3354/14757
= 19.16% = 22.78%

28
The Effects of Capitalizing R&D
 Capitalizing R&D has no effect on FCFF
 Operating Income is increased by the same amount that capital
expenditures are increased.
 So FCFF is the same.

 Why bother Capitalizing R&D then?

 Get a better sense of the profitability of the firm (operating
income and return on capital).
 Better estimate of how much the firm is reinvesting for future
growth (important to estimate growth).

29
Concept Check: Capitalizing R&D
 Amgen Inc is currently spending $845 on R&D.
 Amgen amortizes R&D over a 3-year life span, using a
straight-line method.
 Over the past three years it had R&D expenses of
$822.80, $663.30, and $630.80.
 Its accounting net income (i.e. Its net income treating
R&D as an operating expense) is $1500.
 Its accounting book value of equity is $5,000.
 What is its return on equity after capitalizing R&D?

30
Concept Check Solution: Capitalizing R&D

YearR&D Expense Unamortized portion Amortization this year

0 (current) 845.00 1.00 845.00
-1 822.80 0.67 548.53 $274.27
-2 666.30 0.33 222.10 $222.10
-3 630.80 0.00 0.00 $210.27

Total $ 1615.63 $ 706.64

Value of research asset = $ 1615.63 million
Amortization of research asset in year 0 = $ 706.64 million
Adjustment to net Income = $ 845 million – 706.64 million = 138.4 million
Net income after capitalizing R&D: 1500 + 138.4 = 1638.4
Book Value after capitalizing R&D: 5000 + 1615.63 = 6615.63
Adjusted ROE 1638.4/(5000+1615.63) = 0.248
Note: Old ROE = 1500/5000 =0.30
31
Capitalizing Other Operating Expenses
 R&D Expenses are a good example of capital expenses
being unfairly treated as operating expenses.

 Other examples may include

 Advertising expenses
 A portion of SG&A expenses
 E.g. AOL free trial CDs
 Recruiting and Training employees

 But caution should always be the rule in these adjustments.

There is a reason accounting rules do not make them…

32
Converting Operating Expenses to
Financing Expenses
 Operating Leases are treated as operating expenses but
should be treated as financing expense.
 No real difference between borrowing money to purchase an
asset versus leasing the asset.

 Must make following adjustments to earnings and capital:

 Debt Value of Operating Leases = Present value of Operating
lease commitments at the pre-tax cost of debt
 When you convert operating leases into debt, you also create an
asset to counter it of exactly the same value (both assets and
liabilities increase by the same amount).
 Problem: a lease payment has two components, the lease
interest and the repayment of the implicit principal (the debt).
33
Converting Operating Expenses to
Financing Expenses

 Adjusted Operating Earnings

 Adjusted EBIT= EBIT+ Operating Lease Expenses -
Depreciation on Leased Asset
 Shortcut Adjusted EBIT= EBIT+ Debt Value of Lease * Pretax
Cost of Debt
 Assumes depreciation on leased asset is approximately equal to the
principal portion of the debt being repaid.
 Only use if there is not enough information to compute actual
adjustment.
 If you do not have Rd, this is an useful link to estimate it:
www.stern.nyu.edu/~adamodar/pc/ratings.xls

34
Operating Leases at The Gap in 2003

 The Gap has a stated EBIT of 1,012 and conventional debt of about $ 1.97 billion on
its balance sheet. Its pre-tax cost of debt is 6%. Its operating lease payments in 2003
were $978 million and its commitments for the future are below:
Year Commitment (millions) Present Value (at 6%)
1 $899.00 $848.11
2 $846.00 $752.94
3 $738.00 $619.64
4 $598.00 $473.67
5 $477.00 $356.44
6&7 $982.50 each year $1,346.04
Debt Value of leases = $4,396.85 (Also value of leased asset)
 Debt outstanding at The Gap = $1,970 + $4,397 = $6,367
 Adjusted Operating Income = $1,012 + 978 - 4397/7 (7 year life for assets) = $1,362
million

35 Shortcut Adjusted Operating Income = 1012 + 4397 * .06 = 1275.82
The Collateral Effects of Treating Operating
Leases as Debt
 Suppose the following is true of GAP in 2002:
 BV of Equity = 3130
 Conventional Debt = 1970
 Market Equity = 7350
 After Tax Cost of Debt =4%
 Tax rate = 35%
 Cost of Equity = 8.2%

36
The Collateral Effects of Treating Operating
Leases as Debt
Conventional Accounting Operating Leases Treated as Debt
Income Statement Income Statement
EBIT = 1,012 EBIT+ Leases = 1,012+978= 1,990
Deprecn: OL = 4397/7= 628
Adj. EBIT = EBIT+ Leases- Deprecn: OL
= 1,362
Interest expense will rise to reflect the conversion
of operating leases as debt. Net income should
not change.
Balance Sheet Balance Sheet
Off balance sheet (Not shown as debt or as an Asset Liability
asset). Only the conventional debt of $1,970 OL Asset 4397 OL Debt 4397
million shows up on balance sheet. Total debt = 4397 + 1970 = $6,367 million
BV of equity = 3130.

Cost of equity for The Gap = 8.20% Cost of capital = 8.20%(7350/13717) + 4%

After-tax cost of debt = 4% (6367/13717) = 6.25%
Market value of equity = 7350
Cost of capital = 8.20%(7350/9320) +
4%(1970/9320) = 7.31%
Return on capital = 1012 (1-.35)/(3130+1970) Return on capital = 1362 (1-.35)/(3130+6367)
= 12.90% = 9.30%

37
Concept Check: Converting Operating
Leases to Debt
 Apple leases many of its retail stores.
 In the most recent year Apple had an operating lease of 2,500,
 Over the next two years it has a commitment of $2000 per year.
 In year 3, Apple has a lump sum commitment of $5000.
 Thus the lease life is 3 years.
 Apple has a pre-tax cost of debt of 7%.

 Apple currently has a book value of equity of $100,000 and bv of debt of 0.

 Apple currently has operating income of $20,000 and uses straight line depreciation.

 What is the debt-to-equity ratio for apple after converting operating leases to a
financing expense?

 What is the adjusted operating income?

38
Concept Check Solution: Converting
Operating Leases to Debt

 First compute present value of liabilities:

Year Commitment (millions) Present Value (at 7%)
1 $2000 $1869.16
2 $2000 $1746.88
3 $5000 $4081.49
Debt Value of leases = $7697.53
 Adjusted EBIT= Stated OI + OL exp this year - Deprec =
$20,000 + 2,500 - 7698/3 = $19,934
 Shortcut Adj. EBIT= $20,000 m + 7697.52 * .07 = $20,538.83
 New (book) Debt to equity ratio: 7698/100,000 = 0.08

39
One-time Extraordinary Events
 Firms often report one time charges (e.g. Major restructuring).
 If you use earnings that incorporate one time charges, current
earnings will not be reflective of typical earnings.
 Solution: simply exclude one time charge.

 Often ‘one time’ charges occur more frequently (e.g. every

five years).
 Don’t take company characterizations of non-recurring charges at
face value. Look at the firm’s history.
 Solution: smooth out expense based on frequency
 If expense occurs every five years, use 1/5 of the total expense as a proxy
for the annual effect on net income.

40
One-time Extraordinary Events
 Some firms have revenues / expenses that have zero expected
value but vary a lot from year to year
 Example: gains / losses due to changes in currency values. Or gains
or losses in hedging portfolios for oil producers.
 In those cases it is better to assume the zero expected value for the
future.

 Divestitures (sale of holdings) for non-financial firms

 Gains / losses from sale of holdings or other assets
 If rare, best ignored
 If regular, then they should still be ignored once estimating the
income but their impact on capital expenditures should be considered:
 Net CAPEX= Capex- Depreciation – Divestiture proceeds

41
Income from marketable securities
 If a security is marketed (ex: share in another company) then we
already have a market value

 It does not make sense to estimate (with error!) its value (estimate a g
and an adequate cost of capital)

 Better to simply ignore the income from securities and add instead its
market value
 Example: Say that a firm expects to produce in year t+1 after-tax cash flows
of 200 but 20% of these come from holding securities with a market value of
500. The rest comes from operating assets. Assume a g of 5% and a r of
10%. Then:
 V=160/(0.1-0.05)+500=3700

42
 From earnings to cash flows

Damodaran Ch. 10

43
Cash Flows

 The value of an asset comes from its capacity to generate cash

flows. When valuing a firm the cash flows should be:
 After Taxes
 After reinvestment needs

 Steps to estimate cash flows to the firm:

 Measure earnings (as previously discussed)
 Estimate portion going to taxes (I‘ll just give you a tax rate)
 Estimate portion going to reinvestment

 When measuring equity value, we should also exclude debt

payments.
44
Reinvestment Needs

 The cash flows available to investors in a firm are computed after

reinvestments.

 Net Capital Expenditures (Net Capex)

 Subtract net capex from earnings (Net Capex = CapEx – Depreciation)
 Capex: does not affect earnings but reduces cash flows
 Depreciation: reduces earnings but does not affect cash flows (non-cash expense)

 Investments in non-cash working capital

 Subtract changes in WC from earnings (WC= Inventory + A/R – A/P)
 Inventory – does not affect earnings but reduces cash flows (it is just like an investment).
 Accounts Receivables (A/R) – increases earnings but is not a cash flow (non-cash revenue)
 Accounts Payable (A/P) – decreases earnings but is not a cash outflow (non-cash expense)

45
Net CapEx
 Net CapEx = CapEx – Depreciation
 Capex = any spending designed to create future revenue.
Examples include:
 Buying a new plant
 Upgrading a computer system
 Investing in R&D
 CapEx does not include COGS since these are related to current
(but not future) revenue.

46
Net Capex
 Capex is easily obtained from financial statements but...
 Capex is volatile
 Should smooth out Capex based on long run average
 If firm is growing, may make sense to estimate it as a % of revenue.
 If data not available or reliable (new firm), we can use an industry average
(capex as % of revenue or depreciation)

 Many capital expenditures are omitted

 Need to convert R&D from operating expense to capital expense.
 Acquisitions are not classified as capital expense but should be.

47
Capital expenditures should include
 R&D expenses .The adjusted net capex will be
 Adjusted Net Capital Expenditures = Net Capital Expenditures
+ Current year’s R&D expenses - Amortization of R&D

 Acquisitions of other firms, since these are like capital

expenditures. The adjusted net cap ex will be
 Adjusted Net Cap Ex = Net Capital Expenditures +
Acquisitions of other firms - Amortization of such acquisitions
 Most firms do not do acquisitions every year. Hence, a normalized
measure of acquisitions (looking at an average over time) should be
used

48
Estimating Net CapEx: Cisco 1999

 In 1999, Cisco’s financial statement revealed:

 Capex: 584
 Depreciation: 486
 acquisitions: $2516 (assume this is representative of a typical year)
 Recall R&D of Cisco (assumed 5-year life)
Year R&D Expense Unamortized portion Amortization this year
1999 (current) 1594.00 1.00 1594.00
1998 1026.00 0.80 820.80 $205.20
1997 698.00 0.60 418.80 $139.60
1996 399.00 0.40 159.60 $79.80
1995 211.00 0.20 42.20$42.20
1994 89.000.00 0.00 $17.80
Total $ 3,035.40 $ 484.60
Value of research asset = $ 3,035.4 million
Amortization of research asset in 1999 =$ 484.6 million
Adjustment to Operating Income = $ 1,594 million - 484.6 million = 1,109.4 million
49
Cisco’s Net Capital Expenditures in 1999

CISCO had total acquisitions of $2516. Then adjusted net Capex would
be:
Cap Expenditures (from statement of CF) = $ 584 mil
- Depreciation (from statement of CF) = $ 486 mil
Net Cap Ex (from statement of CF) = $ 98 mil
+ R & D expense = $ 1,594 mil
- Amortization of R&D = $ 485 mil
+ Acquisitions = $ 2,516 mil
Adjusted Net Capital Expenditures = $3,723 mil

(We assume that amortization of acquisitions was included in the

depreciation number)
50
Working Capital Investments

 Working capital, from a cash flow perspective, is the

difference between non-cash current assets (inventory and
accounts receivable) and non-debt current liabilities
(accounts payable)
 Any investment in this measure of working capital ties up
cash. Any increases (decreases) in working capital will reduce
(increase) cash flows in that period.
 When forecasting future growth, it is important to forecast the
effects of such growth on working capital needs, and build
these effects into the cash flows.

51
Working Capital: General Propositions

 Changes in non-cash working capital from year to year are volatile. A

better estimate of non-cash working capital needs is to look at non-
cash working capital as a proportion of revenues
 Can be estimated with firm average over recent history or with industry
averages

 Some firms have negative changes (and/or levels) in non-cash working

capital. Assuming that this will continue into the future will generate
positive cash flows for the firm. While this is indeed feasible for a
period of time, it is unlikely to persist forever. Thus, we need to be
careful when forecasting for firms with negative working capital.
 Better to estimate changes in working capital needs as a % of future revenues
 Not reasonable to assume that levels in working capital can continue to grow
more negative forever. May want to set long-term values to 0.
52
Concept Check: Estimating Free Cash
Flows
 Revtech reported the following in 2009:
 $500 million in revenue and $420 million in operating expenses.
 $30 million in Capex
 $20 million in depreciation
 R&D expenses of $50 million.
 Assume three year amortizable life
 Expenses in past 3 years were, 20, 30, 40 million respectively.
 A/P were 5% of revenue, A/R were 10% of revenue.
 Inventory remained unchanged at 5.
 The tax rate = 40% and the firm has no debt
 The working capital in 2008 was 25.

 What are Revtech’s free cash flows to equity in 2009?

53
Concept Check Solution: Estimating Free
Cash Flows
 EBIT: 500 – 420 = 80 million.
 Net Income = 80 * (1-.4) = 48
 Adjusted Income = 48 + 50 – (20+30+40)/3 = 68
 Adjusted CapEx = 30 + 50 = 80
 Adjusted Depreciation = 20 +(20+30+40)/3 =50
 Adjusted Net Cap Ex = 10+50- (20+30+40)/3 =30
 Change in WC = 30– 25= 5
 FCFE = 68 – 30 -5 = 33
 Note: you would get the same FCFE if you did not treat R&D
as CapEx. However, good idea to always capitalize R&D,
because often will matter.
54
 Estimating Growth

Damadoran Ch. 11

55
Cash Flow Growth
 Recall
t n
CFt
Value  
 1 r 
t
t 1

 This requires that we estimate CF for every year in the

future.
 Not feasible to estimate specific cash flows far in the future.
 Instead, often estimate current cash flows and the future growth
rate of cash flows.

56
Ways of Estimating Growth in Earnings
I. Look at the past
 The historical growth in earnings per share is usually a good
starting point for growth estimation

II. Look at what others are estimating

 Analysts estimate growth in earnings per share for many firms. It
is useful to know what their estimates are.

III. Look at fundamentals

 Ultimately, all growth in earnings can be traced to two
fundamentals - how much the firm is investing in new projects,
and the returns of those projects.
57
I. Historical Growth in EPS
 Some complications in estimating historical growth rates
 Arithmetic versus Geometric Averages?
 How do we deal with negative earnings?
 How long should we look back?
 How far can we extrapolate in the future?

58
Motorola: Arithmetic versus Geometric
Growth Rates

Re ve nue s % Cha nge EBITDA % Cha nge EBIT % Cha nge

1994 $ 22,245 $ 4,151 $ 2,604
1995 $ 27,037 21.54% $ 4,850 16.84% $ 2,931 12.56%
1996 $ 27,973 3.46% $ 4,268 -12.00% $ 1,960 -33.13%
1997 $ 29,794 6.51% $ 4,276 0.19% $ 1,947 -0.66%
1998 $ 29,398 -1.33% $ 3,019 -29.40% $ 822 -57.78%
1999 $ 30,931 5.21% $ 5,398 78.80% $ 3,216 291.24%
Arithme tic Ave rage 7.08% 10.89% 42.45%
Ge ome tric Ave rage 6.82% 5.39% 4.31%
S tandard de viation 8.61% 41.56% 141.78%

Arithmetic Average (Revenues): (21.54+3.46+6.51-1.33+5.21)/5

= 7.08%

Geometric Average (Revenues): (30,931/22,245)1/5 -1 = 6.82

59
A Test
 You are trying to estimate the growth rate in earnings per
share at Time Warner from 1996 to 1997. In 1996, the
earnings per share was -0.05. In 1997, the expected
earnings per share is 0.25. What is the growth rate?
 -600%
 +600%
 +120%
 Cannot be estimated

60
Dealing with Negative Earnings
 When the earnings in the starting period are negative, the
growth rate cannot be estimated. (0.30/-0.05 = -600%)
 There are a couple of ‘solutions’ (none of which are very
good):
 Use the higher of the two numbers as the denominator (0.30/0.25
= 120%)
 Use the absolute value of earnings in the starting period as the
denominator (0.30/0.05=600%)

 When earnings are negative, the growth rate is meaningless.

Thus, while the growth rate can be estimated, it does not tell
you much about the future.
61
The Effect of Size on Growth: Callaway Golf

Year Net Profit Growth Rate

1990 1.80
1991 6.40 255.56%
1992 19.30 201.56%
1993 41.20 113.47%
1994 78.00 89.32%
1995 97.70 25.26%
1996 122.30 25.18%
Geometric Average Growth Rate = 102%

62
Extrapolation and its Dangers

Year Net Profit

1996 $ 122.30
1997 $ 247.05
1998 $ 499.03
1999 $ 1,008.05
2000 $ 2,036.25
2001 $ 4,113.23

 If net profit continues to grow at the same rate as it has in the past 6
years, the expected net income in 5 years will be $ 4.113 billion.

 Growth rates are a function of firm size. If the firm is changing in size,
not appropriate to extrapolate far into future.
63
Example: Google
 Over the past 5 years the net income of Google grew at about 23% a
year. Could this rate of growth go on indefinitely? Why not?

 In the long run the output of the US economy should grow at about 2%
in real terms. Assume inflation of 2%.

 In 2013, Google profits were 12.92B. US GDP was about 16800B.

 What would happen if these two trends persisted?

12.92(1  g GOOGL ) n  16800(1  gUS GDP ) n  12.92 1.23n  16800 1.04 n  n  43

 Think about it…

64
II. Analyst Forecasts of Growth
 While the job of an analyst is to find under and over valued stocks
in the sectors that they follow, a significant proportion of an
analyst’s time is spent forecasting earnings per share.

 Analysts spend a disproportionate amount of time forecasting next

quarter’s earnings per share. One quarter’s earnings per share have
a relatively small impact on the value of a firm though.

 Analyst forecasts of earnings per share and expected growth are

widely disseminated by services such as Zacks and IBES.
 http://finance.yahoo.com/q/ae?s=AAPL+Analyst+Estimates
 http://au.finance.yahoo.com/q/ae?s=RIO.AX

65
Quality of earnings forecasts
 Analysts have more information than historical growth:
 Firm-specific, industry and macroeconomic recent public
information
 Private information (whispered earnings)

 Do they beat historical methods?

 O’Brien (1988) finds they do for the near term (1 or 2 quarters),
not for longer horizons
 Cragg and Malkiel (1968) – find they perform bad at long-term
forecasting.
 La Porta (1996) – analysts seem to extrapolate too much (way
too much…).
66
 La Porta (1996, JF)

Reproduced from table II of La Porta, Expectations and the Cross Section of Stock returns,1996, JF

• From 1982 to 1991, investing against analyst forecasts produced an

annual return of 20.8%

• Analysts tend to make systematic error in expectations and correct

them in the subsequent years

• Partly, errors come from extrapolating recent past

67
III. Fundamental Growth Rates

Investment Current Return on

in Existing Investment on Current
Projects
X Projects
= Earnings
$ 1000 12% $120

Investment Next Period’s Investment Return on

Next
in Existing
Projects
$1000
X Return on
Investment
12%
+ in New
Projects
$100
X Investment on
New Projects
12%
= Period’s
Earnings
132

Investment Change in Investment Return on

+
in Existing ROI from in New Investment on
Projects
X current to next Projects
X New Projects Change in Earnings
$1000 period: 0% $100 12% = $ 12

68
 Growth Rate Derivations
In the special case where ROI on existing projects remains unchanged and is equal to the ROI on new projects

Investment in New Projects Change in Earnings

Current Earnings X Return on Investment = Current Earnings

100 $12
120 X 12% = $120

Reinvestment Rate X Return on Investment = Growth Rate in Earnings

83.33% X 12% = 10%

in the more general case where ROI can change from period to period, this can be expanded as follows:

Investment in Existing Projects*(Change in ROI) + New Projects (ROI) Change in Earnings

Investment in Existing Projects* Current ROI = Current Earnings

For instance, if the ROI increases from 12% to 13%, the expected growth rate can be written as follows:

$1,000 * (.13 - .12) + 100 (13%) $23

$ 1000 * .12 = $120
= 19.17%

69
Expected Long Term Growth in EPS
 The inputs we need to estimate long term growth are:
Reinvestment Rate = Retained Earnings/ Current Earnings =
1 – DPS/EPS =Retention Ratio
Return on Investment = ROE = Net Income/Book Value of Equity

 If we assume ROE is expected to remain unchanged:

gEPS = Retained Earningst-1/ NIt-1 * ROE
= Retention Ratio * ROE
= b * ROE

 Proposition 1: The expected growth rate in earnings for a

company cannot exceed its return on equity in the long
term.

70
Estimating Expected Growth in EPS: ABN
Amro
 Current Return on Equity = 15.79%

 Current Retention Ratio = 1 - DPS/EPS = 1 - 1.13/2.45 =

53.88%

 If ABN Amro maintains its current ROE and retention

ratio, its expected growth in EPS will be:
Expected Growth Rate = 0.5388 (15.79%) = 8.51%

71
Expected ROE changes and Growth
 Assume now that ABN Amro’s ROE next year is expected
to increase to 17% (for new projects only) while its
retention ratio remains at 53.88%. What is the new
expected long term growth rate in earnings per share?
 Long term growth = .17 * .5388 = .0916 or 9.16%

72
Changes in ROE and Expected Growth
 When the ROE is expected to change,

gEPS= b *ROEt+1 +(ROEt+1– ROEt)/ ROEt

 Proposition 2: Small changes in ROE translate into large changes in

the expected growth rate.
 The lower the current ROE, the greater the effect on growth of changes in
the ROE.

 Proposition 3: No firm can, in the long term, sustain growth in

earnings per share from improvements in ROE.
 Corollary: The higher the existing ROE of the company (relative to the
business in which it operates) and the more competitive the business in
which it operates, the smaller the scope for improvement in ROE.

73
Changes in ROE: ABN Amro
 Assume now that ABN’s expansion into Asia will push up the
ROE to 17% (for all existing and new projects), while the
retention ratio will remain 53.88%. The expected growth rate in
that year will be:

gEPS = b *ROEt+1 + (ROEt+1– ROEt)/ ROEt

=(.5388)(.17)+(.17-.1579)/(.1579)
= 16.83%
 (.5388) * (.17)= 9.16% = long term growth for new projects
 (.17-.1579)/(.1579) = 7.67% = change in existing projects

 Note that 1.21% improvement in ROE translates into almost a

doubling of the growth rate from 8.51% to 16.83%.
74
Concept Check: Estimating Growth Using
Fundamentals
 Suppose Con Ed has a current Return on Equity of 11.63% and a
retention ratio of 29.96%

 Suppose the firm will be able to improve its overall return on

equity (for all investments) to 13% this year and the following
year, and that the retention ratio remains at 29.96%.

 What is the growth rate in EPS this year?

 What is the growth rate in EPS in the following year?
 What is the annualized arithmetic growth rate over the 2 years?
 What is the annualized geometric growth rate over the two years?

75
Concept Check Solution: Estimating
Growth Using Fundamentals

 Expected Growth in EPSt= ROEt * Ret Ratio + (ROEt – ROEt-1)/

ROEt-1
 0.13*0.2996 + (0.13-0.1163)/0.1163 = 15.67%

 Expected Growth in EPSt+1 = ROEt+1 * Ret Ratio = 0.13 * 0.2996 =

3.89%

 Annualized two year arithmetic mean: (15.67% + 3.89%)/2 = 9.78%

 Annualized two year geometric mean: (1.1567 * 1.0389)1/2 -1=9.62%

76
ROE and Leverage
 ROE = ROC + D/E [ROC - i (1-t)]

Where:
ROC = EBITt (1 - tax rate) / Book value of Capitalt-1
D/E = BV of Debt/ BV of Equity
i = Interest Expense on Debt / BV of Debt
t = Tax rate on ordinary income
Note: This equality assumes no cash.

 In general, Book value of capital = Book Value of Debt +

Book value of Equity - Cash.
77
Decomposing ROE: Brahma in 1998
 Return on Capital = 687 (1-.32) / (1326+542+478) =
19.91%

 (NOI/(E+ long term debt + short term debt))

 Debt/Equity Ratio = (542+478)/1326 = 0.77

 After-tax Cost of Debt = 8.25% (1-.32) = 5.61%

 Return on Equity = ROC + D/E (ROC - i(1-t))

19.91% + 0.77 (19.91% - 5.61%) = 30.92%
78
Decomposing ROE: Titan Watches (India)
 Return on Capital = 713 (1-.25)/(1925+2378+1303) =
9.54%

 Debt/Equity Ratio = (2378 + 1303)/1925 = 1.91

 After-tax Cost of Debt = 13.5% (1-.25) = 10.125%

 Return on Equity = ROC + D/E (ROC - i(1-t))

9.54% + 1.91 (9.54% - 10.125%) = 8.42%

79
Alternative Measurement of Growth

 The retention ratio (1 – DPS/EPS) assumes that

reinvested earnings are invested in projects earning the
return on equity.

 Also assumes the firm does not raise new capital.

 If firms raise new capital by issuing equity, then the growth in
net income can be different than the growth in EPS.
 Need a measure of investment that goes beyond retained earnings –
Equity Reinvested

80
Equity Reinvestment Rate
 Equity Reinvested in Business:
 Net Capital Expenditures + Change in Working Capital – Net
Debt Issued

 Equity Reinvestment Rate:

 Equity Reinvested in Business/Net Income

 Expected GrowthNet Income = Equity Reinvestment Rate *

ROE

 Ex: http://www.4-traders.com/APPLE-INC-4849/
81
Young firms, abnormal ROC or negative
 In some cases the recent performance of the firm can not be
seen as representative of what we could expect for the long run
(example: Linkedin or Amazon)

 Possible solution: construct a scenario assuming revenue

growth rates, operating margins (EBIT/Sales) or RoC
converges to some long run sensible target (industry or
economy-wide averages)

 Can assume a period of 5-10 years and an expression for the

convergence such as:
X t  wX t 1  (1  w) X Long run
82
Closure in Valuation: Estimating
terminal value

Damodaran Ch.12

83
Getting Closure in Valuation
 A publicly traded firm potentially has an infinite life. The
value is therefore the present value of cash flows until infinity:
t =  CF
Value =  t
t
t = 1 (1 + r)

 Since we cannot estimate cash flows forever, we estimate cash

flows for a “growth period” and then estimate a terminal value,
to capture the value at the end of the period:

t = N CF
Value =  t  Terminal Value
(1 + r) t (1 + r) N
t =1

84
Ways of Estimating Terminal Value

Terminal Value

Liquidation Multiple Approach Stable Growth

Value Model

Most useful Easiest approach but Technically soundest,

when assets makes the valuation but requires that you
are separable a relative valuation make judgments about
and when the firm will grow
marketable at a stable rate which it
can sustain forever,
and the excess returns
(if any) that it will earn
during the period.

85
Stable Growth and Terminal Value

 When a firm’s cash flows grow at a “constant” rate forever,

the present value of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate

 This “constant” growth rate is called a stable growth rate and

cannot be higher than the growth rate of the economy in which
the firm operates.
 Why?

86
Limits on Stable Growth
 The stable growth rate cannot exceed the growth rate of
the economy but it can be set lower.
 If you assume that the economy is composed of high growth
and stable growth firms, the growth rate of the latter will
probably be lower than the growth rate of the economy.
 The stable growth rate can be negative. The terminal value will
be lower and you are assuming that your firm will disappear
over time.

 One simple proxy for the nominal growth rate of the

economy is the riskfree rate.

87
Growth Patterns
 A key assumption in all discounted cash flow models is the
period of high growth, and the pattern of growth during that
period. In general, we can make one of three assumptions:
 there is no high growth, in which case the firm is already in stable
growth
 there will be high growth for a period, at the end of which the growth
rate will drop to the stable growth rate (2-stage)
 there will be high growth for a period, at the end of which the growth
rate will decline gradually to a stable growth rate(3-stage)
 Each year will have different margins and different growth rates (n
stage)

 All companies will eventually reach stable growth.

88
Determinants of Growth Patterns
 Size of the firm
 Success usually makes a firm larger. As firms become larger, it becomes much more
difficult for them to maintain high growth rates

 Current growth rate

 While past growth is not always a reliable indicator of future growth, there is a
correlation between current growth and future growth. Thus, a firm growing at 30%
currently probably has higher growth and a longer expected growth period than one
growing 10% a year now.

 Barriers to entry and differential advantages

 Ultimately, high growth comes from high project returns, which, in turn, comes from
barriers to entry and differential advantages.
 The question of how long growth will last and how high it will be can therefore be
framed as a question about what the barriers to entry are, how long they will stay up
and how strong they will remain.

89
Concept Check: Terminal Value
 Alloy Mills is a textile firm that is currently paying dividends of
$100 million. The firm has no debt.

 The firm is expected to have a return on equity of 20% for the

next 3 years. Its reinvestment ratio is 50%

 After year 3 the growth rate of the firm is expected to drop to 5%

forever.

 The cost of equity for the firm is 10%

 What is the PV of the terminal equity value of the firm?

90
Concept Check Solution: Terminal Value
 The firm has a growth rate of 10% (.20 * .5) for the next
3 years.

 The expected dividends in year 4 is:

 100 * (1.10)3 * (1.05) = 139.75

 The terminal value of the firm at t=3 is:

 139.75/(.10 -0.05) = 2795

 The present value of the terminal value is:

 2795/(1.10)3 = 2100.16
91
Dividend Discount Model

DamodaranCh.13

92
Putting it all together
 We now know:
 How to estimate cash flows in a given period
 How to estimate the growth rate of cash flows
 How to estimate the terminal value of the firm

 We can now put this all together to find the value of

equity (or the value of the firm).

93
What cash flows to use?

 When thinking about cash flows to equity holders we can

think about two different definitions of cash flows:

 Dividends – In the strictest sense, this is the only cash flow

that an investor will receive from an equity investment.

 Free Cash Flows to Equity (FCFE) – the potential dividends

that a firm could have paid. The cash left over after the firm
has paid all expenses and made all necessary investments.
 FCFE will often differ significantly from actual dividends.
 http://appleinsider.com/articles/12/08/14/apple_gearing_up_to_pay_out_2
5_billion_in_dividends_on_thursday
94
Measuring cash flows to equity: should I
discount dividends or FCFE?
 Use the Dividend Discount Model
 (a) For firms that pay dividends close to the Free Cash Flow to
Equity (over an extended period)
 (b)For firms where FCFE is difficult to estimate (Example: Banks
and Financial Service companies)
 http://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm09.pdf

 Use the FCFE Model

 (a) For firms that pay dividends significantly higher or lower than
the FCFE. As a rule of thumb, if dividends are less than 80% of
FCFE or greater than 110% of FCFE over a 5-year period.
 (b) For firms that do not pay dividends.

95
Dividend Discount Models: The
Gordon Growth Model
 Let’s start with the simpler model of valuing stocks:
present value of expected dividends.

 In the steady-state growth stage we can use the Gordon

Growth Model (GGM) to value the stock:
 Where DPS1 is the expected dividend next year, ke is the
cost of equity, and g is the ‘stable’ growth rate of dividends.

DPS1
Valuestock 
ke  g

96
Limitations of the Gordon Growth Model
 Very sensitive to final growth rate

 Appropriate for a limited number of firms

 Firms should have a growth rate equal to or lower than the
nominal growth in the economy
 Firms should have well established dividend policies that they
intend to continue in the future.
 If a firm currently pays out significantly less dividends than it can
afford to, the model will understate true value.

97
Concept check: Using GGM to value ConEd
 ConEd is in stable growth; based upon size and the area that it
serves. Its rates are also regulated; It is unlikely that the
regulators will allow profits to grow at extraordinary rates.

 Firm characteristics are consistent with stable, DDM model

firm
 The beta is 0.20. We will adjust its beta to 0.2*2/3+1/3=0.47
 The risk free rate is 2.60% and we assume a market risk premium of
4%
 The firm pays out dividends that are roughly equal to FCFE.
 Average Annual FCFE between 1999 and 2004 = $635 million
 Average Annual Dividends between 1999 and 2004 = $ 624 million
 Dividends as % of FCFE = 98%

98
Using GGM to value ConEd
 Most recent dividends: 2.60
http://finance.yahoo.com/q?s=ED&ql=0

 Expected Growth Rate in Earnings and Dividends is

roughly 2%
 http://finance.yahoo.com/q/ae?s=ED+Analyst+Estimates

 The price of ConEd is $65.61 (on February 13th, 2015)

 Do you believe ConEd is over or undervalued?

99
Using GGM to value ConEd
Cost of Equity = 2.60% + 0.47*4% = 4.48%
Value of Equity per Share = $2.60*1.02 / (.0448 -.02) = $
106.94

Based on this estimate, the stock appears undervalued.

What are some other possibilities?

100
Estimating Implied Growth Rate
 One possibility is that our growth rate is too high.

 To estimate the implied growth rate in Con Ed’s current

stock price, we set the market price equal to the value, and
solve for the growth rate:
 Price per share = $ 65.61 = $2.60*(1+g) / (.0448 -g)
 Implied growth rate = 0.5%

 The implied growth rate is what the ‘market’ believes.

 Our estimate is higher than the implied rate which is one
explanation for why our price is higher than the market price.
 Is our estimate better than the market?

101
Two Stage DDM
 Allows for two stages of growth
 Initial phase where the growth rate is not stable
 Subsequent stable growth period

n
DPSt DPS n 1 1
Value t    
t 1 (1  k e , hg ) ke , st  g n (1  k e,hg )
t n

Where:
DPSt=expected dividends per share in year t
ke = cost of equity (hg: high growth, st: stable growth)
hg= extraordinary growth rate for first n years
gn = growth rate forever after year n.

102
Limitations of Two-Stage DDM
 Need to define length of extraordinary growth period.

 Assumes the growth rate is high over an initial period and is

immediately transformed to a stable growth rate.

 Focus on dividends will lead to biased results for firms that are
not paying out as much in dividends as they can.

 Model works best for:

 Firms that are in high growth and expect to maintain that growth for
a specific period of time. (e.g. a firm with patent)
 Stable dividend policy.
103
Using 2-Stage DDM to value ABN-AMRO
 As a financial service institution, estimating FCFE is more
difficult.
 Using dividends is more appealing.

 The expected growth rate based upon the current return on

equity of 16% and a retention ratio of 51.35% is 8.22%.
This is higher than what would be a stable growth rate
(roughly 4% in Euros).
 Thus can’t use a plain GGM.

104
ABN Amro: Summarizing the Inputs
 Market Inputs
 Long Term risk-free Rate (in Euros) = 4.35%
 Risk Premium = 4% (U.S. premium : Netherlands is AAA rated)

 Current Earnings Per Share = 1.85 Eur; Current DPS = 0.90 Eur;

Variable High Growth Phase Stable Growth Phase

Length 5 years Forever after yr 5
RoE 16.00% 8.35% (Set = Cost of equity)
Payout ratio 48.65% (0.90/1.85) 52.10% (1 - 4/8.35)
Retention ratio 51.35% 47.90% (b=g/ROE=4/8.35)
Expected growth .16*.5135=.08224% (Assumed)
Beta 0.95 1.00
Cost of Equity 4.35%+0.95(4%) 4.35%+1.00(4%)
=8.15% = 8.35%

Note: We assume here that the new ROE applies only to the new projects.

105
ABN Amro: Valuation
Year EPS DPS PV of DPS (at 8.15%)
1 2.00 0.97 0.90
2 2.17 1.05 0.90
3 2.34 1.14 0.90
4 2.54 1.23 0.90
5 2.75 1.34 0.90

Expected EPS in year 6 = 2.75(1.04) = 2.86 Eur

Expected DPS in year 6 = 2.86*0.5210=1.49 Eur
Terminal Price (in year 5) = 1.49/(.0835-.04) = 34.20 Eur
PV of Terminal Price = 34.20/(1.0815) 5 = 23.11Eur

Value Per Share = 0.90 + 0.90 + 0.90 + 0.90 + 0.90 + 23.11 = 27.62 Eur
The stock was trading at 18.55 Euros on December 31, 2003

106
S & P 500 - rationale for using the two-
stage model
 Markets overall do not grow faster than the economy. But in the US
earnings have outpaced nominal GNP growth over the last 5 years and it is
currently expected they will continue to do so in the next 5 years.

 The consensus estimate of growth in earnings is roughly 8% (in March

2015)
 https://finance.yahoo.com/q/ae?s=IBM+Analyst+Estimates

 Though it is possible to estimate FCFE for many of the firms in the S&P
500, it is not feasible for several (financial service firms).

 The dividends during the year should provide a reasonable (though

conservative) estimate of the cash flows to equity investors from buying
the index.

107
Concept Check: Valuing the S&P 500 Using
a two-step DDM
 On 1/1/2001 the S&P 500 was trading at 1320.

 The dividend yield (D/P) was 2.5%

 Analysts were estimating that the earnings of the stocks in the index
would increase by 7.5% a year for the following 5 years.

 Beyond year 5, the expected growth rate was 5%

 The risk free rate was 5.1% and assume a market risk premium of 4%

 Was the Index over or undervalued?

108
Concept Check Solution: Valuing the S&P 500 Using
a Dividend Discount Model

1 2 3 4 5
Expected Dividends 35.48 38.14 41.00 44.07 47.38
Present Value 32.52 32.04 31.57 31.11 30.65

Current Dividend = 1320 * 0.025 = $33.00

Year 1 Dividends = 33 * 1.075 = 35.48
Cost of Equity = 5.1% + 1(4%) = 9.1%
Terminal Value = 47.38 * (1.05)/(.091-.05) = 1213.39
PV of Terminal Value = 1213.39/1.0915= 785.01
Value of Index = 32.52 + 32.04 + 31.57 + 31.11 + 30.65 + 785.01=
942.90
The index appears considerably over-valued. Our estimate suggests
that it was overvalued by (1320/942.9) -1 = 40%
109
Explaining the Difference

 The index was at 1320, while the model valuation came

at 942.9. This is consistent with any of the following:
 The dividend discount model understated the value because
dividends are less than FCFE.
 The expected growth in earnings over the following 5 years
was much higher than 7.5%.
 The expected growth rate of 7.5% was expected to persist for
much longer than 5 years.
 The risk premium used in the valuation (4%) was too high
 The market was overvalued.
 The index declined by 11% in 2001, and 22% in 2002

110
Concept Check: Valuing the S&P 500 in the
present using a Dividend Discount Model
 On 3/3/2015 the S&P 500 was trading at 2117.

 The dividend yield (D/P) was 1.92%

 Analysts were estimating that the earnings of the stocks in the

index would increase by 7.87% a year for the next 5 years.

 Beyond year 5, assume an expected growth rate of 2.08%

 The risk free rate was 2.08% and the market risk premium was 4%

 Is the Index over or undervalued?

111
Free cash flows to equity
discount model

Discounted Ch.14

112
Dividends and Cash Flows to Equity
 The only cash flows that an investor will receive periodically from an
equity investment in a publicly traded firm is the dividend that will be
paid on the stock.

 Actual dividends, however, are set by the managers of the firm and may
be much lower than the potential dividends (that could have been paid
out)
 managers are conservative and try to smooth out dividends
 managers like to hold on to cash to meet unforeseen future contingencies and
investment opportunities

 When actual dividends are less than potential dividends, using a model
that focuses only on dividends will understate the true value of the
equity in a firm.
113
Measuring Potential Dividends
 Some analysts assume that the earnings of a firm represent its
potential dividends (see Dow 36,000). This cannot be true for
several reasons:
 Earnings are not cash flows, since there are both non-cash revenues and
expenses in the earnings calculation
 Even if earnings were cash flows, a firm that paid its earnings out as
dividends would not be investing in new assets and thus could not grow
 Valuation models, where earnings are discounted back to the present, will
over estimate the value of the equity in the firm

 The potential dividends of a firm are the cash flows left over after
the firm has made any “investments” it needs to create future
growth and net debt repayments (debt repayments - new debt
issues)
114
FCFE
 Cash flows to Equity for a Levered Firm
Net Income
- (Capital Expenditures - Depreciation)
- Changes in non-cash Working Capital
- (Principal Repayments - New Debt Issues)
= Free Cash flow to Equity

115
Estimating FCFE when Leverage is Stable
 FCFE = Net Income- (1- ) (Capital Expenditures -
Depreciation)- (1- ) Changes in Working Capital
 Where:  = Debt/Capital Ratio

 This is basically saying that capital expenditures and

working capital are financed using a fixed mix of debt and
equity (in terms of book values).

116
Example Estimating FCFE: Disney in 1996
 Net Income=$ 1533 Million
 Capital spending = $ 1,746 Million
 Depreciation = $ 1,134 Million
 Increase in non-cash working capital = $ 477 Million
 Debt to Capital Ratio = 23.83%
 Estimating FCFE (1997):

Net Income $1,533 Mil

- (Cap. Exp - Depr)*(1-DR) $465.90 [(1746-1134)(1-.2383)]
Chg. Working Capital*(1-DR) $363.33 [477(1-.2383)]
= Free CF to Equity$ 704 Million

Dividends Paid $ 345 Million

117
 FCFE Models. What are the options?

 Much like the DDM, FCFE models can have multiple stages:
 If firm has reached stable growth then we can use a 1-stage model:
FCFE1
Valuestock 
ke  g n

 If firm is expected to grow faster than a stable firm for an initial period
and then reachn aFCFE
stable rate FCFE we use two stage1 model:
Value t   t
 n 1

t 1 (1  k e , hg ) t
k e , st  g n (1  k e , hg ) n

 If a firm is expected to go through 3 stages of growth: an initial phase of

high growth, a transitional period where growth declines, and a stable
n1 period
FCFEwe usen a three stage
FCFE
2 model: FCFEn 1 1
Value t   t
  t
t  n1
 2

t 1 (1  ke ,hg ) t
t  n1 1 (1  ke ,tran ) (1  ke ,hg ) n1
ke, st  g n (1  ke ,hg ) n1 (1  ke,tran ) n2 n1
118
Which Growth Pattern Should I use?
 If your firm is:
 large and growing at a rate close to or less than growth rate of the economy, or
 constrained by regulation from growing at rate faster than the economy
 has the characteristics of a stable firm (average risk & reinvestment rates)

Use a Stable Growth Model

 If your firm:
 Is large & growing at a moderate rate (≤ Overall growth rate + 10%) or
 has a single product & barriers to entry with a finite life (e.g. patents)

Use a 2-Stage Growth Model

 If your firm:
 Is small and growing at a very high rate (> Overall growth rate + 10%) or
 has significant barriers to entry into the business
 has firm characteristics that are very different from the norm

Use a 3-Stage or n-stage Model

119
Concept Check: Using FCFE to Value Nestle
 The fundamentals of the firm suggest growth of about
15% and rf is 4%.
 Suggests a three-stage model but we will use the two stage
growth model.

 Nestle has a debt to capital ratio of 37.6%, let us assume it

will not change much.

 Like many large European firms, Nestle pays less in

dividends than its FCFE.

120
Concept Check: Using FCFE to Value Nestle
 General Inputs:
 Long Term Government Bond Rate (Sfr) = 4%
 Current EPS = 108.88 Sfr; Current Revenue/share =1,820 Sfr
 Capital Expenditures/Share=150 Sfr; Depreciation/Share=73.8 Sfr

High Growth Stable Growth

Length 5 years Forever after yr 5
Discount Factor 8.47% same
Return on Equity 23.63% 16% (new projects only)
Retention Ratio 65.10% (Current) 25% (based on 4% growth, 16% ROE)
Expected Growth 23.63%*.651= 15.38% 4.00%
Debt Ratio37.60% 37.60%
NWC/Revenues 15.41% 15.41%
Net Cap Ex grow with earnings consistent with retention

What is the equity value of Nestle?

121
Concept Check Solution: Using FCFE to Value
Nestle
1 2 3 4 5
Earnings $125.63 $144.95 $167.25 $192.98 $222.67
- (Net CpEX)*(1-DR) $54.86 $63.30 $73.04 $84.28 $97.24
-D NWC*(1-DR)$26.92 $31.06 $35.84 $41.35 $47.72
Free Cashflow to Equity $43.84 $50.59 $58.37 $67.35 $77.71
Present Value $40.42 $43.00 $45.74 $48.65 $51.75
Earnings per Share in year 1 = 108.88(1.1538) = 125.63
Net Cap Ex(1-DR)_1: (150-73.8) * 1.1538*(1-.376)=54.86
D NWC(1-DR)_1: (1820*.1538) * .1541* (1-.376) =26.92
Earnings per Share in year 6 = 222.67(1.04) = 231.58
Equity Reinvestment in year 6: EPS * Reinvestment Rate: 231.58 * .25= 57.89
FCFE6 = 231.58 - 57.89= 173.68 Sfr
Terminal Value per Share = 173.68/(.0847-.04) = 3885.50 Sfr
Value= $40.42 +$43 +$45.74 +$48.65 +$51.75 +3885.50/(1.0847)5=2817.17 Sf

122
 Fundamental principles of relative
valuation
Damadoran Ch. 17

123
The Essence of relative valuation
 In relative valuation, the value of an asset is compared to
market values for similar assets.

 To do relative valuation then,

 we need to identify comparable assets and obtain its market
values
 convert these into standardized values, since the absolute prices
cannot be compared. This process creates price multiples.
 compare the standardized values or multiples for the
comparable assets, controlling for any differences between the
firms that might affect the multiple (ex: risk).

124
Relative valuation is pervasive…
 Most valuations on Wall Street are relative valuations.
 Almost 85% of equity research reports are based upon a multiple and
comparables.
 More than 50% of all acquisition valuations are based upon multiples.
 Rules of thumb based on multiples are not only common but are often the
basis for final valuation judgments.

 While there are more discounted cash flow valuations in consulting

and corporate finance, they are often relative valuations
masquerading as discounted cash flow valuations.
 The objective in many discounted cash flow valuations is to back into a
number that was first obtained by using a multiple.
 The terminal value in a significant number of discounted cash flow
valuations is estimated using a multiple.

125
So, you believe only in intrinsic value? Here’s why
you should still care about relative value
 Even if you are a true believer in discounted cash flow
valuation, presenting your findings on a relative valuation
basis will make it more likely that your findings /
recommendations will find a receptive audience.

 In some cases, relative valuation can help find weak spots

in discounted cash flow valuations and fix them.

 The problem with multiples is not in their use but in their

abuse.

126
Advantages of Relative Valuation
 Can be completed with far fewer explicit assumptions
than DCF analysis

 Simpler to understand, easier to present, and quicker to

compute

 Will generally yield values closer to the market price than

DCF.
 Problem: Ignores stance on whether overall market is correctly
valued.
 But appropriate for managers with an equity mandate.

127
Limitations of Relative Valuation
 Very difficult to come up with true comparable firm
 Many similar firms will still differ with respect to risk, growth,
or cash flows.

 Ignores overall market valuation

 Important for investors concerned about asset allocation

 Lack of transparency in assumptions make relative

valuation easy to manipulate
 Can almost always find ‘comparable’ firms to justify a
recommendation

128
Standardized Values and Multiples
 You can standardize by dividing by the:
 Earnings of the asset
 Price / Earnings Ratio (PE) and variants (PEG and
Relative PE), Value / EBIT, Value / EBITDA, Value /
Cash Flow
 Book value of the asset
 Price / Book Value (of Equity) (PBV), Value / Book Value
of Assets, Value / Replacement Cost (Tobin’s Q)
 Revenues generated by the asset
 Price / Sales per Share (PS), Value / Sales
 Asset or Industry Specific Variable (Price / kwh, Price per
ton of steel ....)

129
The Four Steps to Understanding Multiples
 Define the multiple
 The same multiple can be defined in different ways by different users. When
comparing and using multiples, estimated by someone else, it is critical that we
understand how the multiples have been estimated
 Describe how the multiple compares to a “normal” value
 Too many people who use a multiple have no idea what its cross sectional
distribution is. If you do not know what the cross sectional distribution of a
multiple is, it is difficult to look at a number and pass judgment on whether it is
too high or low. (Suggestion: http://people.stern.nyu.edu/adamodar/ )
 Analyze the multiple
 It is critical that we understand the fundamentals that drive each multiple, and
the nature of the relationship between the multiple and each variable.
 Apply the multiple
 Defining the comparable universe and controlling for differences is far more
difficult in practice than it is in theory.

130
Definitional Tests
 Is the multiple consistently defined?
 Proposition 1: Both the value (the numerator) and the
standardizing variable (the denominator) should be to the
same claimholders in the firm. The value of equity should be
divided by equity earnings or equity book value, and firm
value should be divided by firm earnings or firm book value.

 Is the multiple uniformly estimated?

 The variables used in defining the multiple should be estimated
uniformly across assets in the “comparable firm” list.
 If earnings-based multiples are used, the accounting rules to measure
earnings should be applied consistently across assets. The same rule
applies with book-value based multiples.

131
Descriptive Tests
 What is the average and standard deviation for this multiple, across the universe
(market)?

 What is the median for this multiple?

 The median for this multiple is often a more reliable comparison point.

 How large are the outliers to the distribution, and how do we deal with the outliers?
 Throwing out the outliers may seem like an obvious solution, but if the outliers all lie on
one side of the distribution (they usually are large positive numbers), this can lead to a
biased estimate.

 Are there cases where the multiple cannot be estimated? Will ignoring these cases
lead to a biased estimate of the multiple?

 How has this multiple changed over time?

132
Analytical Tests
 What are the fundamentals that determine and drive these multiples?
 Proposition 2: Embedded in every multiple are all of the variables that
drive every discounted cash flow valuation - growth, risk and cash flow
patterns.
 In fact, using a simple discounted cash flow model and basic algebra should
yield the fundamentals that drive a multiple

 How do changes in these fundamentals change the multiple?

 The relationship between a fundamental (like growth) and a multiple (such
as PE) is seldom linear. For example, if firm A has twice the growth rate of
firm B, it will generally not trade at twice its PE ratio
 Proposition 3: It is impossible to properly compare firms on a multiple,
if we do not know the nature of the relationship between fundamentals
and the multiple.

133
Analytical Test: Example

 What does a P/E ratio really tell us?

 Consider the stable DDM
DPS
V  P0 
ke  g n
P0 DPS1 / EPS0 ( DPS0 / EPS0 )(1  g n ) payout(1  g n )
PE    
EPS0 ke  g n ke  g n ke  g n

 The variables that influence the PE ratio include:

 Risk (ke)
 Growth (gn)
 Cash Flows (DPS1 or Payout Ratio)
134
Application Tests
 Given the firm that we are valuing, what is a “comparable” firm?
 Traditional analysis is built on the premise that firms in the same sector
are comparable firms. But valuation theory suggests that comparable
firms are similar to the one being analyzed in terms of fundamentals,
whether they are or not in the same sector.
 Proposition 4: There is no reason why a firm cannot be compared
with another firm in a very different business, if the two firms have
the same risk, growth and cash flow characteristics.

 Given the comparable firms, how do we adjust for differences

across firms on the fundamentals?
 Proposition 5: It is impossible to find an exactly identical firm to
the one you are valuing.

135
Controlling for Differences across firms
 No matter how carefully you construct your list of comparable firms, your
firms will not be identical with respect to cash flows, growth, & risk.

 How can we control for these differences?

 Subjective Adjustments
 A firm has a P/E of 22 compared to comparables of 15. You believe differences in cash
flows, growth and & risk are likely to be too small to explain this difference, your
judgment is the firm is overvalued.
 Modified Multiples
 You explicitly incorporate growth into the P/E multiple (Price to Earnings Growth) to see if
this variable can explain the difference.
 Sector or Market Regressions
 Predicted PE = a + B * Expected Growth + C * Payout Ratio + D * Beta
 Can compare predicted PE to actual PE (i.e. look at residuals) to determine whether a firm
is under / over valued. Check: regressions of multiples on market fundamentals.

136
 Earnings multiples

Damadoran Ch. 18

137
Price Earnings Ratio: Definition
PE = Market Price per Share / Earnings per Share

 Thereare a number of variants on the PE ratio in use. They depend on

how the price and the earnings are defined.

 Price:
 is usually the current price (though some like to use average price over
last 6 months or year).

 EPS:
 Time variants: expected EPS in most recent financial year (current), EPS
in most recent four quarters (trailing), EPS expected in next fiscal year
or next four quarters (both called forward) or EPS in some future year
 Before or after extraordinary items

138
Looking at the distribution…
PE Ratio Distribution: US firms in January 2005

700

600

500

400

Current PE
Trailing PE
300
Forward PE

200

100

0
0-4 4-8 8-12 12-16 16-20 20-24 24-28 28 - 32 32-36 36-40 40-50 50-75 75-100 >100
PE Ratio

139
PE: Deciphering the Distribution

Current PE Trailing PE Forward PE

Mean 48.12 42.86 28.53
Standard Error 3.69 3.39 0.98
Median 23.21 20.65 19.21
Kurtosis 1214.98 1428.36 157.28
Skewness 31.75 32.86 10.85
Minimum 1.15 1.31 1.40
Maximum 10081.26 9713 1017.00
Number of firms 4072 3637 2402.00
Largest(500) 58.90 44.72 29.31
Smallest(500) 12.65 11.11 14.54

140
PE Ratio: Understanding the
Fundamentals
 To understand the fundamentals, start with a basic equity
discounted cash flow model.
 With the dividend discount model,
DPS1
P0 
r  gn

 Dividing both sides by the current earnings per share:

P0 Payout * (1  g n )
 PE =
EPS0 r-g n
 With a FCFE Model:
FCFE1 P0 ( FCFE / Earnings) * (1  g n )
P0   PE 
r  gn EPS0 r  gn
141
PE Ratio and Fundamentals
 Ceteris paribus, higher growth firms will have higher
PE ratios.

 Ceteris paribus, higher risk firms will have lower PE

ratios.

 Ceteris paribus, firms with lower reinvestment needs

(holding growth constant) will have higher PE ratios.

 But other things are difficult to hold equal. High growth

firms also tend to have high risk and reinvestment rates.
142
Using the Fundamental Model to Estimate
PE For a High Growth Firm
 The price-earnings ratio for a high-growth firm is related to fundamentals. In
the case of the two-stage dividend discount model:
(1  g ) n
EPS0 (1  b)(1  g )[1  ]
(1  rHG ) n
EPS0 (1  b)(1  g ) n (1  g n )
P0  
rhg  g (rst  g n )(1  rhg ) n

DPS1 x Growing Annuity factor + PV(Perpetuity starting in period n+1)

 Dividing both sides by the earnings per share:

(1  g ) n
(1  b)(1  g )[1  ]
P0 (1  rHG ) n
(1  b)(1  g ) n (1  g n )
 
EPS 0 rhg  g (rst  g n )(1  rhg ) n

143
Expanding the Model
 In this model, the PE ratio for a high growth firm is a
function of growth, risk and payout, exactly the same
variables as for the stable growth firm.

 The only difference is that these inputs have to be

estimated for two phases - the high growth phase and the
stable growth phase.

 Expanding to more than two phases, say the three stage

model, will mean that risk, growth and cash flow patterns
change in each stage.

144
Example: Estimating a PE Ratio from
Fundamentals
 Assume that you have been asked to estimate the PE
ratio for a firm which has the following characteristics:

High Growth Stable Growth

Expected Growth 25% 8%
Payout Ratio 20% 50%
Beta 1.00 1.00
Number of years 5 years Forever after year 5
 Risk free rate = 6% and risk premium of 5.5%
 What should be the PE Ratio for this firm?

145
Example: Estimating a PE Ratio from
Fundamentals
 Required rate of return = 6% + 1(5.5%)= 11.5%
 Can split into two stages: high growth and low growth and
compute PE as follows:

 (1.25)5 
0.2 * (1.25) * 1  5  5
 (1.115)  0.5 * (1.25) *(1.08)
PE = + 5
= 28.75
(.115 - .25) (.115-.08) (1.115)

146
PE and Growth: Firm grows at x% for 5
years, 8% thereafter
PE Ratios and Expected Growth: Interest Rate Scenarios

180

160

140

120

100 r=4%
PE Ratio

r=6%
r=8%
80 r=10%

60

40

20

0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Expected Growth Rate

147
PE and Risk: Effects of Changing Betas on PE Ratio:
Firm with x% growth for 5 years; 8% thereafter

PE Ratios and Beta: Growth Scenarios

50

45

40

35

30
g=25%
PE Ratio

g=20%
25
g=15%
g=8%
20

15

10

0
0.75 1.00 1.25 1.50 1.75 2.00
Beta

148
V. Comparing PE ratios across firms
Company Name Trailing PE Expected Growth Standard Dev
Coca-Cola Bottling 29.18 9.50% 20.58%
Molson Inc. Ltd. 'A' 43.65 15.50% 21.88%
Anheuser-Busch 24.31 11.00% 22.92%
Corby Distilleries Ltd. 16.24 7.50% 23.66%
Chalone Wine Group Ltd. 21.76 14.00% 24.08%
Andres Wines Ltd. 'A' 8.96 3.50% 24.70%
Todhunter Int'l 8.94 3.00% 25.74%
Brown-Forman 'B' 10.07 11.50% 29.43%
Coors (Adolph) 'B' 23.02 10.00% 29.52%
PepsiCo, Inc. 33.00 10.50% 31.35%
Coca-Cola 44.33 19.00% 35.51%
Boston Beer 'A' 10.59 17.13% 39.58%
Whitman Corp. 25.19 11.50% 44.26%
Mondavi (Robert) 'A' 16.47 14.00% 45.84%
Coca-Cola Enterprises 37.14 27.00% 51.34%
Hansen Natural Corp 9.70 17.00% 62.45%

Note: 22.65
Average It would be
12.60% better to use Beta as a measure of risk, but we will stick with the
33.30%
data given in the book.
149
A Question
You are reading an equity research report on this sector, and the
analyst claims that Andres Wine and Hansen Natural are under
valued because they have low PE ratios (8.96 and 9.70,
respectively compared to an average PE of 22.66). Would you
agree?

 Not necessarily. Andres Wine has one of the lowest expected

growth rates of the firms in the group, which may explain the
low PE ratio. Hansen Natural has a high growth rate but it also
is the riskiest firm (as measured by std dev) in the group, which
may explain its low PE ratio. In other words, not all firms with
low PE ratios are under valued. They may be low-growth, high-
risk companies…
150
Concept Check: Are Andres Wine and
Hansen really undervalued?
 You estimate the following regression:

 Trailing PE= a + b * Exp Growth + c * Std Dev + e

 You find that:

 a = 20.88 (t = 3.01)
 b = 183.24 (t = 3.66)
 c = -63.98 (t =-2.63)

 Do you now believe that Andres Wine is over or under valued?

 Do you now believe that Hansen Natural Corp is over or under valued?

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Concept Check Solution: Are Andres Wine
and Hansen really undervalued?

 We can compute a predicted Trailing PE ratio based on growth and

standard deviation.

 Predicted PEANDRES = 20.88 + 183.24 * (3.50%) -63.98 * ( 24.70%) = 11.49

 The Predicted PE (11.49) is greater than the actual PE (8.96), suggesting that
Andres Wine is still relatively undervalued.

 Predicted PEHANSEN = 20.88 + 183.24 * (17%) -63.98 * (62.45%) = 11.95

 The Predicted PE (11.95) is again greater than the actual PE (9.70), suggesting
that Hansen is still relatively undervalued.

 Note the predicted PEs of both companies are considerably less than the average PE
of 22.66, suggesting that controlling for growth and standard deviation does
account for much of the apparent undervaluation.
152
Fundamental analysis: recent research
 Bibliography:
 Asness, Frazzini, and Pederson (2013), Quality Minus Junk
 Elton and Gruber (2013), Mutual Funds
 Frazzini, Kabiller, and Pederson (2013), Buffet’s alpha
 Gibson, Safieddine, and Sonti (2004, JFE), Smart
Investment by smart money: evidence from seasoned
equity offerings
 Bartram and Grinblatt (2018, JFE), Agnostic
fundamental analysis works

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Fundamental analysis: does it work?
 From a semi-strong EMH perspective, fundamental analysis of
publicly traded securities should be a waist of time

 All publicly available information in balance sheets, income

statements, and analyst forecasts should be already reflected in
the stock price. Some non-public information too...

 There are some well-known examples of fundamental analysis

investors that have been quite successful, but that could be
purely luck.

 Fundamental analysis is widespread among practitioners. If it

worked, professional money managers should be doing better
than their benchmarks.

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Mutual fund performance
 Many studies on this. Elton and Gruber (2013) survey their results (table I of their paper):

 So before expenses, mutual funds seem to (marginally) outperform benchmarks (but after
expenses, not really). Still an open topic though.

155
Mutual fund performance
 Could some be better at stock picking than others?

 Here a bit more consensus.

156
The relevance of fundamental variables
 Fundamental analysis is a laborious process, large choice of
methods (FCFE / GGM, R&D capitalization, what amortization
life…), hard to test directly.

 But it uses observable variables: beta, growth in revenues /

earnings, dividends, leverage, RoE, …

 Ansess, Frazzini, and Pedersen (2013) test whether these

variables are useful or not for investment.

 They sort firms according to “Quality” which they proxy using

some of the variables used in fundamental analysis.
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Quality minus junk: Returns
 Results below (from their table I) show that sorting
produces alpha and SR:

Excess returns of 5-8%

a year from sorting on
quality.

Robust internationally.

Both in recessions and

expansions.
158
Quality minus junk
 Quality measures are persistent:

 Some mean reversion, but still differences persist.

159
Buffet’s alpha
 Thereare millions of investors out there. Trying to explain why one of them
did extremely well should not be a scientific concern.

 One can always ask if there is an issue of “survivorship bias” at work.

 Onthe other hand, this investor claims to follow a method, laid out by Graham
and Dodd (1934) – the founders of fundamental analysis.

 Fundamental analysis has systematic traits and it is followed by many other

investors. Buffet’s method is not one unique, odd approach to investing.

 Frazzini,Kabiller, and Pedersen (2013) examine whether the returns to

Buffet’s investments are just a reflection of luck, or if there is anything more
systematic to it. They use QMJ as a factor to explain its returns. Also BAB.

160
Buffet’s alpha: Comparing to other stocks
 be a scientific concern.

Clearly Buffet’s firm,

Berkshire Hathaway, is an
outlier.

161
Buffet’s alpha with QMJ and BAB as factors

Reproduced from table 4 of the paper.

Buffet’s approach is tilted against size

(has holdings in large firms such as Ko,
IBM, ..)

Large alpha w.r.t. “traditional” factors,

(Fama and French (1992), Carhart
(1997)).

Adding BAB and QMJ we see that his

portfolio loads on those factors.

Alpha still there, but no longer significant.

Summary: A lot of Buffet’s alpha comes

from systematic factors.
162
Agnostic relative valuation
 Bartram and Grinblatt (2018, JFE) test the form of
relative valuation based on regressions on a large
number of firm fundamentals.

 A long-short portfolio of undervalued-minus-

overvalued stocks earns 10% risk-adjusted annual
returns in a sample from 1987 to December 2012.

163
The primary market
 For market prices, in EMH, sophisticated institutional investors
(perhaps using fundamental analysis) should not outperform.

 But when firms issue new stock, prices usually are not market
prices.

 Even if we believe in EMH, one still needs some method to

determine if those non-market prices are high or low relative to
fundamentals. Fundamental analysis?

 Gibson, Safieddine, and Sonti (2004, JFE) examine stock

picking ability of institutional investors in the case of SEO’s.

164
Institutional buying and the SEO

Institutional investors buy

more stocks in (or around)
SEO for some firms
(“High”) and reduce their
exposures in others
(“Low”).

The year following the

issue, stocks in the “High”
group perform much
better.

Suggests institutional
investors are able to pick
stocks - at least in the
primary market.
165
Recent research: Summary
 It is one ongoing debate whether institutional investors outperform their
benchmarks.

 There is dispersion in skill though. Not just luck.

 Simple portfolios constructed on the basis of variables used in fundamental

analysis perform quite well.

 Could be proxy for some other, unknown, risk factor or just reflect market
inefficiencies.

 Regardless of this debate, fundamental analysis should always be useful to

value privately held firms, IPO’s, SEO’s,… The evidence does suggest that
institutional investors do better at stock picking in this context.

166