Equity Analysis

EQUITY ANALYSIS

A. EQUITY VALUATION MODELS

Intrinsic Value of Investments

P = (CF1/(1+r1)) + (CF2/(1+r2)2) + … + (CFn/(1+rn)n) Problem with This Model for Equity:

Irregular & Unpredictible Cash Flows

No Definite Date of Maturity for Common Stock

Discount Rate is not directly observable

NOTE: In performing any analysis of Equity, there is Forecasting Risk that the Analyst is wrong

Ways to MINIMIZE Forecasting Risk

Use SCENARIO Analysis – with ranges & probabilities of valuation

Use SENSITIVITY Analysis – to see how important each variable is to the Valuation

Use SIMULATION Analysis – Monte Carlo Method

Dividend Discount Model

PCS = [D1/(1+rCE)1] + [D2/(1+rCE)2] + … + [D / (1+rCE) ]

Problems:

1.Must Forecast Dividends correctly out to

2.Must choose the Appropriate Discount Rate (Cost of Equity) Simplifications of the Dividend Discount Model

Constant Dividend Model (like a Preferred Stock)

Ppfd = (D1/rpfd)

Constant Growth Dividend Model (dividends grow at g, constant rate, forever) PCS = [ D1 / (rCE – gD)]

Can Re-write the Constant Growth Dividend Model as follows (r – implied rate of return – Cost of Equity)

Rimplied = [ (D1/PCS) + gD]

Earnings Model

P/E1 = [ K / (rCE – gE)]

Determining the Appropriate Discount Rate (2 Methods)

1.Traditional Build-Up Approach

rCE = (1+rrrf)(1+E(inflation))(1+req.risk premium) – 1

rCE = (1+rrf)(1+req.risk premium) –1

Note: rrf is usually thought to be the nominal secular growth rate of the economy over the long term, modified over the short run by current monetary policies & social attitudes toward savings – similar to a 0 coupon treasury with a Horizon = duration of the stock

Note: rerp is usually between 3 & 8 % and is related to the psycholigical factors of the investors, the business & financial risk of the firm, the liquidity of the stock, and the exchange rate & country risks.

a.) Business Risk & Operating Leverage

Business Risk: the uncertainty associated with income flows caused by the nature of the business. It depends upon the volatility of EBIT.

BREAKEVEN: R = PQ

Then Figure out accounting break even EBIT = R – C

But this simple analysis isn’t enough… Try to use DOL & OLE

 DOL = [% CFoperation / % Sales] à OLE = [% EBIT / % Sales]

 DOL = [ (P-q)Q / CFoperations] à OLE = [(P-v)Q / EBIT]

 DOL = [ 1 + ((FCcash)/CFoperation)] à OLE = [ 1 + ((CFC+Depr)/EBIT)]

b.) Financial Risk & Financial Leverage

Financial Risk: uncertainties introduced by the way that a firm is financed.

 DFL = [% CF / % CFoperations] à FLE = [% EBT / % EBIT]

DFL = [CFoperation / CF] à FLE = [EBIT/EBT] NOTE: TOTAL LEVERAGE (Operating & Financial)

DTL = DOL * DFL à TLE = OLE * FLE

DTL = [% CF/% Sales] à TLE = [% EBT/% Sales] HENCE: Risk (Operating & Financial) is a Factor of 3 Things

SALES

Operating Leverage Financial Leverage

c.) Liquidity of Stock

Liquidity can be measured by certain things.

MV S/O

# Shareholders

Trading Turnover

EQUITY RISK PREMIUM can then be determined using a cross-sectionalREGRESSION Anaysis using the following form:

req. risk premium = b0 + b1 (Coefficient of Variation of Sales)(Op. Lev.)(Fin.Lev.) + b2 (liquidity)

2.Security Market Line Approach

In Modern Portfolio Theory, all components of risk are summarized by SYSTEMATIC MARKET RISK that is measured by Beta (which is a measure of risk of a stock relative to that of the stock market as a whole.)

Security Market Line, defined by CAPM, defines the REQUIRED Return on a Stock in terms of its Beta

rCE = rrf + Bs(rm – rf)

This model can then be used to find the implied discount rate for the Dividend Discount Pricing Model to determine the intrinsic value of a stock.

PROBLEMS: how to determine the appropriate Equity Risk Premium for a Market as a whole (using Ibbotson data).

3.Accounting Based Beta Approach

A problem with SML is that it relies on HISTORICAL Beta as being a good estimate of its future Beta.

One Approach is to try to develop a BETA that is based upon current financial Data

IGNORE

Applying Dividend Discount Models to Growth Stocks

1.Three Stage Dividend Discount Model

Make Assumptions about the stages of development; High Growth, Deceleration of Growth, Stable Growth

Use a Computer to Determine future dividends

2.H-Model (2 Stage Dividend Discount Model)

Assumes ONLY 2 Stages of Growth: High & Stable

3.Growth Duration Model

Compare Relative P/E between the Stock & Market

Advantages & Disadvantages of the Dividend Discount Valuation Model

PRO

Simplicity

Able to distinguish Over Valued & Under Valued Firms

CON

Models Apply ONLY to Dividend Paying Stocks

Risk is not an EXPLICIT Function of the market à Largely subjective measure of risk

Small Errors of g & r can result in HUGE errors (therefore, only good to come up with a range)

OTHER VALUATION METHODS

1.P/E Ratios

If Investors have LOW Confidence, tends to be about 7-9

If Investors have HIGH Confidence, tends to be about 15-18

2.Dividend Yields

For Market, Tends to fall toward 3% when there is Excessive Optimism, and up to 6% during periods of Pessimism. In normal times, 3.5-4.5%

3.Price/Sales Ratios

Sales are less prone to Manipulation than Earnings

For Large Firms, should be .4 - .8

4.Price/Asset Value Ratios

S&P 500 between 1.5 –2.0 Price to Book. When pessimistic 1.0-1.5 & when optimistic, 2.0-3.0 Price to Book

PROBLEM: Book Value is Arbitrarty derived from Accounting Conventions. Liquidation might be a little better, but useful ONLY if thinking about breaking up the firm.

TOBIN’s Q-RATIO has been used to measure Values.

Q = [(VE + VD) / VA]

Qs under 1 would be considered a bargain. Qs over 1 could indicate overvaluation if the firm’s management is underutilizing the assets.

GENERAL FREE CASH FLOW VALUATION MODEL

VA = VD + VCE + Vpfd

VCE = VA – VD - Vpfd

PCS = (VCE / NCS)

Valuing the Firm’s Total Debt

Use a Financial Calculator to determine Price for a Bond

VD = [DS1/(1+rD)1] + [DS2/(1+rD)2] + … + [DSn/(1+rD)n]

Valuing the Firm’s Preferred Stock

Vpfd = (Dpfd/rpfd)

Valuing the Firm: Defining Free Cash Flow to the Firm

FCF = CFoperations + Interest Expense – Net Cash Used for Investing – Cash Retained for Business Purpose

FCF = Cash Interest Expense + Net Cash Used for Financing

FCF = EBIT(1-t) + DEPR – NWA – CAPEX + (t*Interest)

EBIT = Earnings before Interest & Taxes, including Gains from Sale of Assets t = Effective Income Tax Rate

DEPR = Depreciation & other NON CASH Expenses

NWA = Adjustments to Revenues, expense, taxes, & cash for business purposes – BOOK calls this Working Capital

CAPEX = Capital Expenditures, other investments, & increases in LTA Interest = Interest Expense

FCF* = EBIT(1-t) + DEPR – NWA – CAPEX

Valuing the Firm: Defining the Discount Rate

Try to find the UNLEVERED Discount Rate (but it is SUBJECTIVE) rU = (1+rrf)(1+rOp. Risk Prem) – 1

can try to find it using Modigliani-Miller

rCE = rU + (rU – rD)(1-t)(VD/VCE) + (rU-rpfd)(Vpfd/VCE) à rCE = rrf + BCS(rm – rrf)

This Might be Too Simplistic with many assumptions (such as Historical à Future)

FCF v. DDM: FCF to the Firm FCF to CE

In theory, FCF & DDM should produce the same value for the common shares of a publicly traded firm. However, in practice, they usually produce different valuations. Which is Better?

Most analysts prefer using the FCF over the DDM.

FCF focus on the key factors: Ability to generate cash from operations, uses of corporate cash, and level of operating risk. More or less ignore the distibutional & financing issues.

B. CORPORATE FINANCE

Many issues that bear on the valuation of a firm require knowledge of how businesses make financial decisions.

How a firm determines whether to raise capital by issuing debt or equity (Capital Structure)

How Dividend Policy is determined

Criteria firms use in making investment decisions

Cost of Capital

The return on assets required to keep the value of the firm in equilibrium is called the firm’s

Weighted Average Cost of Capital (rW) because it represents the AFTER-TAX Cost of each element of the capital structure (debt, preferred equity & common equity) weighted by the percentage of the market value of the firm that is comprised of each source of capital.

rW = [(1-t)rDVD + rpfdVpfd + rCEVCE] / [VD+VP+VCE] à rW = [(1-t)(rD)(VD/VA)] + [(rpfd)(Vpfd/VA)] + [(rCE)(VCE/VA)]

rW is the WACC which is the Discount Rate that should be used when Discounting the UNLEVERAGED FCF of the firm

NOTE: Can Determine the Cost of Equity in 1 of 3 Ways

1.Traditional Build Up

rCE = (1+rrf)(1+req. risk prem.) – 1

2. Implied Rate

rCE = [(D1/PCS) + gD] = [Dividend Yield][1+gD] + gD

3. CAPM

rCE = rrf + BCS(rM – rrf)

Determining the Optimal Capital Structure

Optimal Capital Structure is defined as that which will maximize the value of the firm

Proposition I of the Modigliani-Miller Theorum: The VALUE of a Firm does NOT depend upon its capital structure in a world where no taxes are paid.

Proposition II of the Modigliani-Miller Theorum: In a world without taxes, the firm’s WACC will be unaffected by the Capital Structure

When Taxes are INTRODUCED things change dramatically: The Optimal Tax Structure would be 100% DEBT (due to the Tax Shield & the inherent savings) for both VALUE & WACC

Why, in reality, is 100% debt not the norm? Cost of Financial Distress are higher than predicted in the model.

STATIC Theory of the Capital Structure suggest that debt is beneficial up to a point, beyond which the costs of potential financial distress begin to outweigh the debt benefits.

If Market of Corporate Finance is Efficient, it is to be presumed that the CURRENT Capital Structure of a Firm is its Optimal Capital Structure. In Conclusion,

The Higher the Corporate Tax Rate, the greater the Incentive to use debt in the capital structure

The Greater the Operating Risk, the lower the Optimal Debt:Equity Ratio will be due to the cost of Financial Distress

Management’s Attitude toward risk may also affect how they view the costs of financial distress

Capital Structure Puzzle by Stewart Myers

Rejects STATIC Theory of Capital Structure: Not the Way the World Works

Develops Pecking Order Theory: Firms prefer to raise the funds that are needed to finance desirable investment projects in the following order:

1.Internally Generated Funds

2.If Internal funds are insufficient to finance all worthwhile investments, the firm will issue DEBT first & then EQUITY

Valuing the Common Equity of a Public Firm using the Special Form FCF Model

VCE = [FCF1*/(1+rW)1] + [FCF2*/(1+rW)2] + … + [FCF */(1+rW) ]

PCS = (VCE/#CS)

Like the Dividend Discount Model, the Special Form FCF faces the Eternity Problem. But if assume constant growth, can make the assumptions.

VCE = [FCF1*/(rW – gFCF)] – VD - Vpfd

STEPS in the Analysis

1.Find the FCF1* of the Firm

2.Find rCE

3.Find rW

4.Find VD

5.Use Special Form of the FCF Model

6.Determine Value of Common Shares

C. SUMMARY OF VALUATION MODELS

1.General Form of the FCF using the Leveraged FCF VCE = [FCF1/(rL – gFCF)] – VD – Vpfd

2.General Form of the FCF using the Unleveraged FCF VCE = [FCF1*/(rU – gFCF)] – VD – Vpfd

3.Special Form of the FCF

VCE = [FCF1*/(rW – gFCF)] – VD – Vpfd

4.Dividend Discount Model

VCE = [D1 / (rCE – gD)]

CFA Exam tends to concentrate on the DDM & Special Form FCF to value CE

D. HISTORICAL APPROACH TO FORECASTING Earnings & Sales

1.Perform an Industry Analysis

Demographic & Social Changes

Age Distribution of the Population & Influence on Industry

Distribution of Income which affect type of products in demand

Distribution of the Industrial Mix (move from Smokestack toward high tech)

Regional Employment Patterns

Changing Lifestyles

Governmental Impacts

Regulations which have varying impacts (EPA, OSHA, FCC, etc.)

Taxation & Subsidies (note: Effective Tax Rate, not Statutory, is used in the analysis)

Industry Life Cycle Analysis

Growth (Formative, Rapid, Mature) – Maturity – Decline

Industry Financial Ratios

ROA = (NI/TA)

Debt:Eq = (LTD/TD)

Payout Ratio = (Div./NI)

P/E Ratio = (PCS/EPS)

Div. Yld. = (Divps/PCS)

ROE = (NI/Equity)

2.Forecast Sales

Main Purpose of performing an Industry Analysis is to be able to forecast the probable future Sales of firms operating in it.

Usually, use Regression relating it to GDP and other things

Also, when forecast Sales, should try to forecast BOTH Volume & Price Separately

3.Forecast EBDIT margin of Target Entity

EBDITmargin = (EBDIT/Sales)

EBDIT margin depends upon Many Factors:

Capacity Utilization Rate

Unit Labor Costs

Inflation

Competition

-Barriers to Entry

-Degree of Current Competition in the Industry -Availability of Substitute Products

EBDIT can often be determined by a Multiple Regression:

EBDITmargin = b0 + b1 Cap. Util. Rate + b2% Unit Labor Costs

EBDIT1 = EBDIT0 + EBDIT

4.Forecast Depreciation Expenses

Since it is largely an imbedded cost, based on past capital expenditures dwarfing current investments, this can usually be forecasted by extrapolating the past 15-20 years into the future. However, if new investments are so large, relative to total fixed assets, this is not a good thing to do.

5.Forecast Interest Expenses

Usually done by Extrapolating the past historical trend.

6.Forecast Income Tax Rate

Assume the future rate will be similar to the past, so long as tax laws are expected to be constant.

7.Forecast the Changes in NWA

Using the average of the past Business Cycle of (NWA/Sales)

WC = Sales * (NWA/Sales)Historical

8.Forecast New Investments

What the firm should be doing in the future

New Investments = Sales * (Fixed Assets/Sales)Average

9.Forecast Earnings & Unleveraged Cash Flows

NI = [(Sales*EBDITmargin) – DEPR – INT] * (1-t)

FCF* = [(Sales*EBDITmargin)(1-t)] – NWA – CAPEX + (t)(DEPR)

10.Forecast Common Dividends

DIV1 = NI * Avg. Payout Ratio

CAVEATS to HISTORICAL ANALYSIS

Historical is not always the best predictor of future success. But Historical Analysis should be performed because:

a.) Professional Standards require an analysis of past trends

b.) Critical analysis of history can lead to worthwhile conclusions about value in many circumstances c.) Continuity of historical relationships are the norm, while deviation from history is exceptional

E. FORECASTING GROWTH & THE FINANCIAL APPROACH

 One way to forecast Growth is through a Historical Analysis

 Another Approach is a measure of a firm’s ability to finance its own growth internally: the financial approach

 (NI/Share) = ROCE * BVShare

 Internal Growth Rate = ROCE * Earnings Retention Ratio  g = ROCE (1-K)

F. ANALYZING ROE WITH DUPONT

ROE = NI / Equity

ROE = [NI/Sales]*[Sales/Equity]

ROE = [NI/Sales]*[Sales/Assets]*[Assets/Equity]

ROE = [EBT/Sales]*[Sales/Assets]*[Assets/Equity]*[NI/EBT]

ROE = [Pretax Profit Margin] * [Asset Turnover] * [Financial Leverage Ratio] * (1-t)

Asset Based Version

ROE = [(EBIT/Sales)(Sales/Assets) – (Int.Exp./Assets)]*[Assets/Equity]*[NI/EBT]

ROE = [(EBIT/Assets) – (Int.Exp./Assets)]*[Assets/Equity]*[NI/EBT]

ROE = [Pretax ROA – Int. Exp. Rate] * [Financial Leverage Ratio] * [1 – t]

Sales Based Version

ROE = [EBIT/Sales]*[Sales/Assets]*[Assets/Equity]*[EBT/EBIT]*[NI/EBT]

ROE = (Op. Profit Margin) * (Asset Turnover) * (Financial Leverage Ratio) * (1-t)

ROE = (ROApre-tax) * (Compound Leverage Factor) * (1-t)

Thus, ROE is based on 5 Factors

1.Operating Profit Margin

Measured as EBIT/Sales; Influenced by à

Degree of Competition (higher competition à lower Operating profit margin

Business Cycle: will improve when the good times roll

Strategy of Firm: Volume Seller (low margin) OR Margin/Niche Strategy

2.Asset Turnover

Measured as Sales/Assets : Influenced by à

Technology of Product Production & Distribution

Management’s Ability to EFFICIENTLY utilize its asset base

Business Cycle

3.Financial Leverage

Measured by Asset/Equity à since Assets = Debt + Equity à FLR = 1 + (Debt/Equity) = A/E

Credit Market Conditions

Management’s Attitude towards Debt

Industry Characteristics

4.Cost of Debt

In Asset Based à Int.Exp./Asset : in Sales Based à EBT/EBIT

Measure Cost of Management’s Choice Regarding the Amount of Financial Leverage to Employ

Depends on Management’s Financial Strategy & the Level of Interest Rates

5.Tax Burden

Measured by Tax Retention Rate à NI/EBIT = 1 – t

Function of Tax Code & Effectiveness of Tax Strategy

Computing Depreciation, Depletion, Amortization

Recognition of Revenues

Measuring Tax Deductible Costs

Tax Credits

NOTE Also the

Compound Leverage Factor = (EBT/EBIT)(Assets/Equity) = (Interest Burden)(Financial Leverage)

Caveats on the Usefulness of ROE

1.Timing

Firms may sacrifice earnings in the short run to get long-term benefits.

2.Risk

Magnitude of ROE does not measure the risk taken to obtain it. ROE is usually enhanced through the use of Financial Leverage (which increases risk)

May try to use Return on Invested Capital instead

ROIC = [(EBIT)(1-t)/(Debt + Equity)

3.Valuation

Use Net Book Value of Equity. High ROE may be misleading. Might convert to True ROE

ROETrue = (FCF)/(Net AssetsMarket Value)

Can’t generally obtain data for this

4.Volatility

ROEs fluctuate in response to cyclical & random forces.

PRACTICAL PROBLEMS WITH VALUATION MODELS

1.Dividend Discount Models

Very sensitive to small changes in Discount Rate & Growth Rate (which are difficult to predict)

2.FCF Models

WACC is objectively, but FCF* is difficult to determine from accounting data

Assumes increases in Working Capital are equal to that which is required to maintain existing operations, which may not be true

Assumes firms invest up to the point where the last dollar invested produces a return = WACC

Assumes Current Capital Structure is Optimal

3.Economic Earnings Based Models

Theoretically useful, but accrual accounting has faults

Company Analysis v Stock Selection

Good Firms are not necessarily good investments

Growth Stock Investing à philosophy that good firms are good investments. Invest in the best firms in the best industries (to make your pile, be in style)

Value Investing à philosophy that undervalued stocks are good investments

Growth Companies: have management capability & opportunity to undertake investments projects that produce rates of return that are greater than WACC (can’t last forever)

Growth Stocks: stocks with above-average expected rates of return relative to risk. Need not be growth companies

Defensive Companies: not likely to react sharply to a decline in the general level of economic activity Defensive Stocks: low Betas, regardless of the nature of the firm

Cyclical Companies: sales & earnings rise & fall with fluctuations in business cycle Cyclical Stocks: high beta stocks that rise & fall with bull & bear marketsSpeculative Companies: firms whose business involve great risk

Speculative Stock: overpriced stocks whose returns might be abnormally low because of valuation

G. EVALUATING MANAGEMENT

Economic Value Added Analysis

Good Management invests ONLY in projects that will Enhance the Value of the Firm

Invest in IRR or NPV projects that have better than required risk analysis

TRADITIONAL Measures of Management Performance

Financial Ratio Analysis

EBIT/TA

NI/TA

NI/EquityBook Value

But are poor: subject to manipulation and no account of Risk

Tobin’s Q-Ratio

If less than 1, stock is a bargain: but > 1 not necessarily over valued

Q = (D + E)FMV/AssetsReplacement Value

EVA Analysis

Based on ECONOMIC Profits rather than ACCOUNTING Profits

EVA = NOPAT – rW(Total Capital) = (rC – rW)(Total Capital)

rC = (NOPAT/Total Capital)

NOPAT can be calculated in either the Top-Down or Bottom-Up Method

Step 1. Calculate NOPAT. Develop a company-specific format designed to produce a good approximation of the NOPAT

Top-Down	Bottom-Up
Gross Sales	Operating Income Before Tax
Increase in LIFO	Increase in LIFO
Implied Interest Expense on Op. Leases	Implied Interest Expense on Op. Lease
Other Operating Income	Amortization of Goodwill
(CGS)	Increase in Bad Debt Reserve

(SG&A Expenses)	Adjusted Pretax Operating Profit
(Depreciation)	(Cash Operating Taxes)
Adjusted Pretax Op. Profit	NOPAT
(Cash Operating Taxes)

NOPAT

Step 2. Determine the Total Capital of the Firm. Can use either Asset Approach or Financing Approach. Need to make Company Specific Adjustments so that they are inter-company comparable.

Step 3. Determine the Firm’s Cost of Capital. Use WACC Step 4. Calculate the EVA of the Firm

MVA Analysis

MVA = Total CapitalMarket Value – Total CapitalBook Value

Management Performance = f( MVA)

Tough to Calculate. In theory, MVA = [EVA1/(1+rW)1] + [EVA2/(1+rW)2] +…+

PROBLEMS with Value Added Performance Measures

Economic Profits are based on the Adjusted Accounting Data with lots of Analyst Subjectivity

Cash Flow Return on Investment (CFROI)

Step 1. Determine the Average Life of the Firm’s Assets Step 2. Calculate the Target Firm’s Cash Flow

Step 3. Calculate the Firm’s Gross Cash Investment

Step 4. Estimate the Value of the Firm’s non-depreciating assets at the time the life expires Step 5. Adjust all Historical data to reflect current prices

Step 6. Calculate the CFROI à

Gross Cash Inv. = {[Gross CFi/(1+rCFROI)I] + [E(Term. Value of Non-depreciating assets / (1+rCFROI)n]

Step 7. Compare the CFROI with an appropriate Benchmark

H. ARTICLES

In Search of Excellence & Excellence Revisited by Clayman

From the date firms were recognized as EXCELLENT according to their ratios, those ratios began to deteriorate (underperformed) à Extrapolating past trends does not work.

Excellent: rated as Growth Stocks, while Poor are Value Stocks… Tends to be a Value Market

Depends on the Market Vogue

Managing Growth

Slow growth is generally bad while overheated growth can lead to financing problems

A Firms sustainable growth rate  g* = ROE(1-K)

Equity Valuation by McLaughlin

Denying Efficient Market: Stocks fluctuate above & below their true value and thus it is possible to buy undervalued stocks and sell overvalued ones

Types of VALUE (rather than Price)

Asset Value: Replacement (not required anymore under FASB 33 & tough to determine) or Liquidation (Need lots of Data on Current Values of All Assets to be appraised)

On-going Concern Value: P/E – DDM – CAPM – SML

Strategies for Stock Selection

Sector Rotation

Defensive (food, tobacco, soft drinks) do best in Late Expansion Business Cycle

Interest Sensitive (Utilities, Banks) do best in Early Recovery Business Cycle

Consumer Durables (Autos, Appliances) do best in Middle Recovery/Expansion

Capital – Do best in LATE Recession, just before recovery

Market Timing

Technical Analysis Approach

Valuation Approach

Economic Forecasting

Problem: High Cost Strategy, and in efficient market, should not work

Screens

Find Stocks that meet certain statistical tests (author likes this approach)

Valuation of Common Stock by Graham

Market’s Expectations of future earnings growth are not derived from past performance

Why bother Analyzing: Concensus can be wrong: analysts can be right

Competitive Strategy by Porter

In the Long Run, Rates are Driven down to equal risk-free assets + some minimum business premium. Only in the absence of strong competition can above average returns be earned

Competitive Forces

1.Ease of Entry & Exit (Barriers to Entry)

Large Capital Requirements

Economies of Scale

Secure Distribution Channels

Strong Brand Identification

High Switching Costs

Government Policy

Proprietary Product Differences

Expected Retaliation

Absolute Cost Advantages (Proprietary Learning Curve – Access to Low Cost Imputs – Proprietary Low-cost product design)

2.Rivalry between Existing Competitors

Number of Competitors

Relative Strength of Competitors

Industry Growth

Fixed Costs / Value Added

Perishable Products or High Storage Costs

Product Differences (Commodity or Differentiated)

Large Incremental Additions (Capacity)

Diverse Competitors (Foreign, Size, Strategic Importance of Certain Markets)

Switching Costs

Informational Complexity

High Exit Barriers

3.Pressures from Substitute Products

Inter-Industry Competition

4.Bargaining Power of Buyers (Leverage & Sensitivity to Prices)

Volume of Purchases as a Percentage of Sales

Profitability of the Buyer

Percentage of Buyer Cost that is Represented by the Product (how hard he’ll bargain)

Buyer Information

Threat Toward Backward Integration

Products’ Impact on the Buyer’s Business

Switching Costs

Ability to Influence Others (end-users)

5.Bargaining Power of Suppliers

Relative Size of Suppliers v Buyers

Importance of the Buyer to the Seller

Switching Costs

Forward Integration Threat

Degree of Organization (Cartel – Oligopoly)

Supply of Supplier’s Product

Government Control

Generic Strategies

1.Low-Cost Producer

Most Efficient Producers ONLY can Make a Profit. Must Establish Leadership

Large Scale Production

Vigorous Cost Control

Large Capital Investment

Proprietary Technology

RISKS: Requires Standardization & Long Production runs (reduce flexibility). Technology can make for quick obsolescence

2.Product Differentiation

Can Either be REAL Different or PERCEPTIVE Different

Raise Switching Costs by raising brand loyalty & allowing a premium price to be charged

RISKS (lose to low cost because more of a commodity)

3.Focusing on a Niche

Avoid MASS Market. Focus only a Niche Segment but be the Leader in it.

I. VALUING CLOSELY HELD & INACTIVELY TRADED FIRMS

1.Establish a Fair Market Value of the Enterprise, as you would with another investment (Methods Include)

ADJUSTED Book Value Approach

MARKET Approach (similar companies & values)

DISCOUNTED Cash Flow Approach

2.Adjust this Base Value for the Fact that there is a LIQUIDITY problem & MARKETIBILITY Discount

The Difference between the Public Market Equivalent Value of a firm and its Private Market Value is the Dollar Discount for lack of Marketability

VA* = (1-dmarket)VA

Marketability Discounts vary between 0 to 60% (usually between 35-50%)

Depend on Attractiveness of Industry

Cost of Taking Firm Public

Likelihood of Firm going Public

Size of Firm

Existence of Generally Accepted Valuation Formulas

Existence of PUT Rights

Competitive Nature of Business

Size of Dividend Payments

Information Access

Restrictive transfer Provisions

3.Adjust for potential CONTROL Premiums or Minority Discounts

dMinority are usually between 25-67%

FACTORS:

Cumulative v Non-cumulative Voting Rights

Contractual Restrictions

Governmental Regulations

Distribution of Ownership

Relation between Majority & Minority

Articles of Incorporation

J. COMPANY TAKE-OVERS & RESTRCTURING

Reasons for Restructurings

1.Increase the Use of Interest Tax Shields

2.Re-deploy the Firm’s Assets

3.More Efficient use of CashFlow

Preventing Unfriendly Takeovers

1.Have Charter require Supermajority to approve mergers & have staggered elections for Board

2.Initiate an Exclusionary Self-tender (to all but unfriendly)

3.Adopt Poison Pills (like Share Rights Plan)

4.LBO

5.Negotiate a Lock up

Fighting Unfriendly Takeovers

1.Repurchase or Standstill Agreements

2.Sell-off the Crown Jewels

3.Seek a White Knight

Stock v Cash Acquisition Factors

1.Sharing of Gains between Target firm & Acquiring Firm’s Shareholders

2.Tax Effects of Mergers (most Stock Mergers are Tax Free)

3.Control Considerations

Returns of Take-overs

Most Evidence suggest the S/H of ACQUIRED firms gain substantially while S/H of ACQUIRED firms tend to earn little, if any, extra returns. Why?

Rosey Scenario Syndrome

Whale Swallows Minnow Syndrome Empire Building Syndrome Efficient Market Syndrome

K. VENTURE CAPITAL

Characteristics

1.Returns are High

2.Risks are High

3.Investments are Illiquid

4.Less Efficient (Expertise Pays)

5.Ventures are Entrepreneurial so they must be advised on certain things

6.Difficult to Value

7.Usually Require Additional Financing

Role of Venture Capital Investment Firm

1.EARLY STAGE

Seed Finance (usually <$50,000) – No VC involvement

Start-up Financing –No VC Involvement

1st Stage Financing – Maybe VC, but usually ANGELS

2.EXPANSION STAGE

Some operating history, with a Viable Product

2nd Stage Financing – though growing, still unprofitable

3rd Stage Financing – large, used to finance a big expansion – VC love this

Mezzanine Financing – Preparing for Public Offering

3.TURNAROUND

Provide Capital to restructure.

4.LBOs

Lead investors to purchase the firm’s assets

5.COUNSEL

Build a Management Team to run the large business

Construct a Long-term Business Plan (focus product oriented entrepreneur toward business)

Benefits of Venture Capital

Provide lots of Expertise: only 10-20% failures in their portfolios, compared to 50% failure of all emergings

Venture Capital Fund Management Process

1.Follow a Sound Investment Strategy (stick to industries in which have knowledge, and stay with certain types of stage management)

2.Have a Good Deal Flow Generation Capability (only 1 in 100 deals is worth doing; thus need to attract lots of good potential deals to sift through)

3.Effective Deal Screening (want to eliminate 90-95% of the deals quickly so that detailed analysis & time can be devoted to the rest)

4.Perform DUE DILIGENCE on Firms that Pass the Screen

Determine Strength of Management

Know nature of Product & Market

Financial Projections

Intuitive Analysis

Assess Current Firm Employee’s Abilities

Assess Investment Outlook

5.Value the Target Firm

6.Structure the Investment in the Target

Investing in VC Funds

1.Diversification (Stage of Development – Industry – Region – Vintage Year)

2.Timing of Returns

3.Commitments & Fundings

L. VALUATION OUTSIDE THE US

P/E & P/Book are useless inter-nationally due to ACCOUNTING & CULTURAL Differences

Focus on Cash Flow

M. EVALUATING DISTRESSED & BANKRUPT FIRMS

2 Types of Investors who Invest in Bankrupt & Distressed Firms

1.Investors who Own by Default

2.Investors Seeking out this type of Investment in a B/R firm

Very Risky to Invest here: Seek reason for Distress

1.Financial Distress (firm can generate cash, but it’s capital structure provides a crushing debt burden) Ok to invest in these when try to change Capital Structure

2.Operational Distress (firm can’t generate cash) Bad Investment

When Firm Files for Bankruptcy, it is Valued like an IMBEDDED Call Option