Concept Questions

Concept questions

C 1.1 Fundamental risk is inherent to the business , it is the chance of losing money because of the outcome of business activities. Price risk on the other hand concerns the risk of losing value from buying or selling investments at prices that differ from the intrinsic value.

The difference between them is that fundamental risk considers changes in the future payoffs of an investment due to changes in the business, whereas price risk considers the difference between the value of the future payoffs and the price of the investment.

You can protect yourself from fundamental risk by diversification, you can diminish price risk by performing a fundamental analysis of financial statements.

C 1.2 An alpha technology looks at abnormal returns over the expected return for the risk taken. A beta technology, such as the CAPM, gives an estimate of the required return as the sum of the risk free rate and a risk premium. This premium consists of a risk premium on a risk factor, multiplied by the sensitivity to this risk factor. Alpha technologies are used to identify price risk and possibly trade against it, whereas beta technologies are used to diversify fundamental risk.

C 1.3 An index investor would agree with this statement because the historical S&P 500 average annual return to stocks has been 12.3 percent, compared to 6 percent for corporate bonds and 3.5 percent for treasury bills. The fundamental investor recognizes these statistics but notes that these returns are not guaranteed.

C 1.4 A passive investor assumes that markets are efficient and prices are correct. He requests fundamental risk from analysts, calculated with beta technologies, and then uses these to create a diversified portfolio that diminishes total fundamental risk. (extreme: index investor)

An active investor uses alpha technologies to identify price risk and to possibly trade against it, he assumes that stocks are not always priced correctly. He separates price from value and tries to find the intrinsic value that needs to be the market price.

C 1.5 E/P = 10 % and P/E = 10 could be a normal market P/E compared with a normal stock return of 10 %.

C 1.6 No, the open market would have far less information, the firm knows the fundamental value of the shares. If the open market overestimates share value you want to sell to the open market, if it underestimates share value you want to sell to the firm.

C 1.7 If all investors would be agreeing fundamental investors, no one could earn abnormal returns. If a stock is undervalued, everyone would buy it, which drives the price up to the correct price. If a stock is overvalued, everyone would sell it, which would drive the price down to the correct price. It seems impossible to “outperform” the market if everyone agrees on the valuations. That is why, if this is not the case, fundamental investors could outperform passive investors, because passive investors might buy an overvalued or sell an undervalued stock, due to a lack of information.

C 1.8 If they would all be passive investors, stocks can be over or undervalued, and they would remain this way because no one would trade against these valuations. Prices would depend on betas provided by analysts.

C1.9 a. This indicates that on average, prices were close representations of intrinsic value.

b. In theory I believe it would have, because you bought when it was “cheap” and sold when it was “expensive”.

c. This indicates the creation of a bubble: more and more people buy an overpriced stock, expecting it to go up even more. = Momentum investing.

C 2.1 Changes in shareholders’ equity are determined by total earnings minus net pay-out to shareholders, but the change in shareholders’ equity is not equal to net income (in the income statement) minus net pay-out to shareholders. Why?

Because you have to add other comprehensive income to net income in order to become comprehensive income. Comprehensive income – net pay-out to shareholders = change in equity.

C2.2 Dividends are the only way to pay cash out to shareholders. True or false?

No, you can also repurchase shares.

C2.3 Explain the difference between net income and net income available to common. Which definition of income is used in earnings-per-share calculations?

Net Income – preferred dividends= Net income available to common. The latter is used for EPS calculations.

C2.4 Why might a firm trade at a price-to-book ratio (P/B) greater than 1.0?

There might be a positive intrinsic/market premium.

C2.5 Explain why firms have different price-earnings (P/E) ratios.

The P/E ratio reflects anticipated earnings growth.

C2.6 Explain the difference between accounting value added (earnings) and shareholder value added.

Shareholder value added is a speculative value while accounting value is only added when revenue is booked.

C2.7 Give some examples in which there is poor matching of revenues and expenses.

Estimating long useful lives for plant so that depreciation is understated
Underestimating bad debts from sales so that income from sales is overstated.
Overestimating a restructuring charge

C2.8. Price-to-book ratios are determined by how accountants measure book value. Can you think of accounting reasons for why price-to-book ratios were high in the 1990s? What other factors might explain the high P/B ratios?

Intangible assets were recorded at historical cost. There also might be unrecorded assets. Vb Dell halt veel value uit “ direct-to-consumer” process. Dit is niet opgenomen in de balans omdat de fair value hier heel moeilijk van de evalueren is en dit zou leiden tot speculatieve cijfers.

C2.9 Why are dividends not an expense in the income statement?

The income statement reports how shareholders” equity increased or decreased as a result of business activities. Dividends are not an expense but a distribution of value.

C2.10 Why is depreciation of P&E an expense in the income statement?

Because of the matching principle: “ Expenses are recognized in de income statement by their association with revenues for which they have been incurred.” Incurring the cost of plant & equipment directly as an expense at the date of acquiring goes against the principle.

C2.11 Is amortization of a patent right an appropriate expense in measuring value added in operations?

Yes, if this patent provides revenue over the same amount of time the right is amortized over.

C2.12 Why is the matching principle important?

The difference between revenue and matched expenses is the measure of value added from trading with customers. If you violate this principle, this could lead to incorrect earnings.

C2.13 Why do fundamental analysts want accountants to follow the reliability criterion when preparing financial reports?

Forecasts are only reliable when the reliability criterion is respected. This way the analyst has ‘hard’ information to base his forecasts on.

C3.1: Price to sales ratio equals (p/e) * (e/s) where (e/s) is defined as each dollar of sales that end up in earnings. Differences in p/s explain differences in the profitability of sales.

C3.2: (p/s) and (p/ebit) ratios should be calculated as unlevered ratios because leverage does not produce sales or earnings before interest and taxes. Hence, it is useful to control for differences in leverage between the target firm and comparison firms. Danger: it leaves out interests and taxes.

C3.3: (p/ebitda) adjusts for both leverage and the accounting of these expenses (depreciation and amortization measures can differ). It can be a better way to compare the underlying businesses of companies with different amounts of debt. Ebitda is not only a real economic cost but also an approximation of cash flow. Danger: it leaves out interests, taxes, depreciation and amortization.

C3.4: Price in the numerator of the trailing P/E is affected by dividends: dividends reduce share prices because value is taken out of the firm. Earnings in the denominator are not affected by dividends, so P/E ratios can differ because of differing dividend payouts.

C3.5: p/s = p/e * e/s.  p/s = 12 * 6% = 0.72

C3.6: p/s = p/e * e/s  p/e = 25 / 8% = 312.5

We would expect that there was a mistake in the computation of the p/s ratio because a p/e of that magnitude is very unlikely and uncommon.

C3.7: A glamour (growth) stock is a stock that is fashionable and trades at high multiples (viewed by contrarian investors as overvalued). Value (contrarian) stocks are stocks that trade at low multiples (viewed by value investors as undervalued).

C3.8: An asset based valuation is feasible in a few instances, for example for main assets that are natural resources (such as a forest). An asset based valuation does not incorporate intangible assets, furthermore market values may not be available or efficient, nor might it represent the value in the particular use. In Dell’s case, intangible assets is the major source of the difference between market value and book value. The firm has a brand name that may be worth more than its tangible assets combined.

C3.9: False. The yield on a bond represents the required return on the bond or the cost of capital for debt. The required payoff rate depends on the cash flows that the bond will generate, which depends on the coupon rate.

C3.10 & 11: Dividends don’t create value for shareholders, the investor’s cum-dividend payoff is not affected. Share repurchases can only create value for shareholders if shares are repurchased at a price greater than the market value (which is unlikely). Shares are often repurchased when management sees that market value is below the intrinsic value, which will increase the share price. Share repurchases do increase eps because the number of outstanding shares decrease, however primary reasons to repurchase shares are to increase shareholder’ wealth and counter undervaluation.

C3.12: False. According to the dividend discount model, the value of a share is based on expected dividends; however, dividend pay out ratio depends on a firm’s strategy as well as its net income.

False: Dividend payout over the foreseeable future doesn’t mean much (recall ch. 3 ‘homemade dividend’). Dividends are usually not tied to value creation, only when there is a fixed payout ratio of earnings do they represent value. Dividends are value distribution, not creation.
Cash Is not king. Free cash flow is the mean fundamental that the equity analyst should focus on. Pure cash is biased too much by interest payments, amortization, depreciation, etc..
If cash receipts were matched in the same period with cash investments then we would get a correct view of the NPV of the investment. But DCF analysis doesn’t work that way so it could give a wrong image because it violates the matching principle. Possible solution: very long forecast horizon (not practical).
GE is a typical growth company which invests more cash in operations than it takes in from operations. So FCF is negative because these investments are treated as ‘bad’. When suddenly its FCF become positive this could indicate that GE hasn’t found new positive NPV investment opportunities. So could be bad news because this will reduce future CF.
Accrual revenue minus COGS because these match value inflows and outflows the best.
Different CF from operations versus earnings is due to income statement accruals, the non-cash items in net income. Net income minus these accruals (adjusted for after-tax interests) = CF from operations.
Earnings – accruals – new investments in operations = FCF

FCF(C-I) – i + accruals + I = earnings

They are investments in excess cash until it can be invested in operations later
Levered CF is the reported CF in the CF statement of the firm. This includes the interest from leverage through debt financing. What we really need is the unlevered CF from operations where the adjustments for net interest payments and investments in interest-bearing-securities have been made.
Because interest receipts are taxable and interest payments are deductable from taxable income, the net interest payments must be adjusted for the tax payments they attract or save.

True,
V(E) = B0 + RE1/ re + RE2/r²e+… and residual earnings are determined by (ROCE - required return on equity)*beginning of period book value of common equity. This shows us that with residual earnings the value has to be higher than the book value and therefore the shares are mispriced.

The market views this ROCE as normal. This proven by the fact that P/B is around one which means a correct valuation of the firm.

A P/B ratio lower than one means that market judges the value of a firm lower than that of its operatings assets. This can only be the case if the firm’s operations destroy value. However by the expected RE of 2% each year the firm will create value and therefore its overall value will rise and exceed that of its assets. In an efficient market this will be recognized by the investors and thus the value of the shares will rise. The advice to hold shares is correct.

True,
The required return is based on the CAPM and WACC. Both formulas take as well risk as the price of capital into account. If a company earns less than it’s required return, investors will turn to investments with (larger) RE for the same risk or the same pay-off for less risk.

RE are determined by ROCE- required and book value. If ROCE is higher than the required return value will be added to firm’s book value each year. Therefore the RE will keep rising. The result has to treated with cautiousness because the PV of the RE remains almost the same over the years.

False,
The higher return of the intangible assets will be reflected by the higher RE earnings the firm will achieve. If the brand is really that strong, it will be a reason of a very high return on the required return on equity (which can be low in comparison with the value of the intangible asset).

If the analyst would forecast net income, the firm would be valued in a wrong way. The value of a company is dependent not only on net income but also on other factors.

The statement isn’t correct at all. FCF does not measure value added from operations over a period. It is measured by the cash flow from operations flowing into firm minus cash investment. Normally speaking a company is worth more if it invests in profitable projects. It can therefore be useful for a company to have negative cashflow due to heavy investments in order to be more profitable in the future.

1)This is because Dividend payout is irrelevant to valuation, for cum-dividend earnings growth is the same irrespective of dividends.

2)This is solved at follows, firms in the S&P 500 pay dividens; indeed, the historical dividend payout ratio has been about 45 percent of the earnings. This 8.5% growth is an ex-dividend growth rate. The cum-dividend growth rate wih 45% payout is about 13%.

3)It is wrong because it is applied with forecasts of ex-dividend growth rates rather than cum-dividends growth rates. Ex-dividend growth rates ignore growth from reinvesting dividends. Second, the formula clearly does not work when the earnings growth rate is greater than the required return.

4)
Normalforward: 1/0,12= 8,33
normaltrailing: 1,12/0,12= 9,33

5)This represent that one current dollar remains earning at the required return fora n extra year. Just as a normal P/E implies that forward earnings are expected to grow, cumdividend, at the required rate of return after the forward year. So a normal trailing P/E implies that current are expected to grow, cum-dividend, at the required rate of return after the current year.

6)In the formula you se that the discounted value of abnormal earnings growth supplies the extra value over that from capitalized forward earnings. Reinvest dividends in the firm at the 10 percent rate. Subsequent earnings within the firm will increase by the amount of reinvested dividends. Cum-dividend earnings- the amount of earnings earned in the firm plus that earned by reinvesting the dividends outside the firm – will be exactly the same as if the SH reinvested the dividends in a personal account. Exibit 6.2

7)Yes, pag 208.

8)They expect that it is different because the risk of bonds and stocks is different. Can be false or true depends on how much Abnormal earnings you incalculate, when a lot the statement is true and stocks have higher P/E. And vice versa.

9)No it is possible when you anticipate a lot of abnormal earnings, but you should be careful with this valuation. Because the abnormalearningsaren’tabsolutlycertain.

10) The PEG ratio compares the P/E ratio to a forecast of percentage earnings growth rate in the following year. If Ratio is smaller than 1. The screener concludes that the market is underestimating earnings growth. And vice versa.

11)

12) when prices increase the P/E ratio will increase this is a contradiction when they say that the P/E is decreasing.

13)

14)

C 8.1. It is called dirty-surplus income because the net income in the income statement is not clean, not complete.

C 8.2. Not all gains are included in the net income, there is other comprehensive income : dirty surplus items (gains that are not yet realized) and hidden dirty expenses (when transactions occur at prices other than market prices)