2016 Schweser Notes. CFA. Level 2. Book 3: Equity

320 Pages·9.734 MB·English

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BooK 3 -
EQUITY
Readings and Learning Outcome Statements ............................................................. v
Study Session 10 - Equity Valuation: Valuation Concepts ......................................... 1
Study Session 11 - Equity Valuation: Industry and Company Analysis
in a Global Context ................................................................................................ 3 5
Study Session 12 - Equity Investments: Valuation Models ...................................... 134
Self-Test - Equity. ................................................................................................. 297
Formulas ............................................................................................................... 302
Index .................................................................................................................... 307
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SCHWESERNOTES™ 2016 LEVEL II CFA® BOOK 3: EQUITY
©2015 Kaplan, Inc. All rights reserved.
Published in 2015 by Kaplan, Inc.
Printed in the United States of America.
ISBN: 978-1-4754-3531-3
PPN: 3200-6843
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Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth
by CFA Institute in their 2016 Level II CFA Study Guide. The information contained in these Notes
covers topics contained in the readings referenced by CFA Institute and is believed to be accurate.
However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam
success. The authors of the referenced readings have not endorsed or sponsored these Notes.
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READINGS AND
LEARNING OUTCOME STATEMENTS
READINGS
The following material is a review oft he Equity principles designed to address the learning
outcome statements set forth by CFA Institute.
STUDY SESSION 10
Reading Assignments
Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015)
29. Equity Valuation: Applications and Processes page 1
30. Return Concepts page 13
STUDY SESSION 11
Reading Assignments
Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015)
31. The Five Competitive Forces That Shape Strategy page 35
32. Your Strategy Needs a Strategy page 53
33. Industry and Company Analysis page 62
34. Discounted Dividend Valuation page 89
STUDY SESSION 12
Reading Assignments
Equity, CFA Program Curriculum, Volume 4, Level II (CFA Institute, 2015)
35. Free Cash Flow Valuation page 134
36. Market-Based Valuation: Price and Enterprise Value Multiples page 180
37. Residual Income Valuation page 226
38. Private Company Valuation page 258
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Book 3 - Equity
Readings and Learning Outcome Statements
(LOS)
LEARNING OUTCOME STATEMENTS
STUDY SESSION 10
The topical coverage corresponds with the following CFA Institute assigned reading:
29. Equity Valuation: Applications and Processes
The candidate should be able to:
a. define valuation and intrinsic value and explain sources of perceived mispricing.
(page 1)
b. explain the going concern assumption and contrast a going concern value to a
liquidation value. (page 2)
c. describe definitions of value and justify which definition of value is most
relevant to public company valuation. (page 2)
d. describe applications of equity valuation. (page 2)
e. describe questions that should be addressed in conducting an industry and
competitive analysis. (page 4)
f. contrast absolute and relative valuation models and describe examples of each
type of model. (page 5)
g. describe sum-of-the-parts valuation and conglomerate discounts. (page 6)
h. explain broad criteria for choosing an appropriate approach for valuing a given
company. (page 7)
The topical coverage corresponds with the following CFA Institute assigned reading:
30. Return Concepts
The candidate should be able to:
a. distinguish among realized holding period return, expected holding period
return, required return, return from convergence of price to intrinsic value,
discount rate, and internal rate of return. (page 13)
b. calculate and interpret an equity risk premium using historical and forward
looking estimation approaches. (page 15)
c. estimate the required return on an equity investment using the capital asset
pricing model, the Fama-French model, the Pastor-Stambaugh model, macro
economic multifactor models, and the build-up method (e.g., bond yield plus
risk premium). (page 19)
d. explain beta estimation for public companies, thinly traded public companies,
and nonpublic companies. (page 24)
e. describe strengths and weaknesses of methods used to estimate the required
return on an equity investment. (page 26)
f. explain international considerations in required return estimation. (page 26)
g. explain and calculate the weighted average cost of capital for a company.
(page 27)
h. evaluate the appropriateness of using a particular rate of return as a discount
rate, given a description of the cash Row to be discounted and other relevant
facts. (page 27)
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publisher's prior permission. Violators will be prosecuted.
Book 3 - Equity
Readings and Learning Outcome Statements
STUDY SESSION 11
The topical coverage corresponds with the following CFA Institute assigned reading:
31. The Five Competitive Forces That Shape Strategy
The candidate should be able to:
a. distinguish among the five competitive forces and explain how they drive
industry profitability in the medium and long run. (page 35)
b. describe why industry growth rate, technology and innovation, government,
and complementary products and services are fleeting factors rather than forces
shaping industry structure. (page 38)
c. identify changes in industry structure and forecast their effects on the industry's
profit potential. (page 39)
d. explain how positioning a company, exploiting industry change, and shaping
industry structure may be used to achieve a competitive advantage. (page 40)
The topical coverage corresponds with the following CFA Institute assigned reading:
32. Your Strategy Needs a Strategy
The candidate should be able to:
a. describe predictability and malleability as factors in assessing an industry. (page 53)
b. describe how an industry's predictability and malleability are expected to affect
the choice of an appropriate corporate strategy (classical, adaptive, visionary, or
shaping). (page 54)
c. evaluate the predictability and malleability of an industry and select an
appropriate strategy. (page 5 5)
The topical coverage corresponds with the following CFA Institute assigned reading:
33. Industry and Company Analysis
The candidate should be able to:
a. compare top-down, bottom-up, and hybrid approaches for developing inputs to
equity valuation models. (page 62)
b. compare "growth relative to GDP growth" and "market growth and market
share" approaches to forecasting revenue. (page 62)
c. evaluate whether economies of scale are present in an industry by analyzing
operating margins and sales levels. (page 63)
d. forecast the following costs: cost of goods sold, selling general and administrative
costs, financing costs, and income taxes. (page 63)
e. describe approaches to balance sheet modeling. (page 66)
f. describe the relationship between return on invested capital and competitive
advantage. (page 67)
g. explain how competitive factors affect prices and costs. (page 67)
h. judge the competitive position of a company based on a Porter's five forces
analysis. (page 67)
1. explain how to forecast industry and company sales and costs when they are
subject to price inflation or deflation. (page 68)
j. evaluate the effects of technological developments on demand, selling prices,
costs, and margins. (page 70)
k. explain considerations in the choice of an explicit forecast horizon. (page 71)
l. explain an analyst's choices in developing projections beyond the short-term
forecast horizon. (page 72)
m. demonstrate the development of a sales-based pro forma company model.
(page 73)
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Book 3 - Equity
Readings and Learning Outcome Statements
The topical coverage corresponds with the following CFA Institute assigned reading:
34. Discounted Dividend Valuation
The candidate should be able to:
a. compare dividends, free cash flow, and residual income as inputs to discounted
cash flow models and identify investment situations for which each measure is
suitable. (page 89)
b. calculate and interpret the value of a common stock using the dividend discount
model (DOM) for single and multiple holding periods. (page 92)
c. calculate the value of a common stock using the Gordon growth model and
explain the model's underlying assumptions. (page 95)
d. calculate and interpret the implied growth rate of dividends using the Gordon
growth model and current stock price. (page 96)
e. calculate and interpret the present value of growth opportunities (PVGO) and
the component of the leading price-to-earnings ratio (P/E) related to PVGO.
(page 97)
f. calculate and interpret the justified leading and trailing P/Es using the Gordon
growth model. (page 98)
g. calculate the value of noncallable fixed-rate perpetual preferred stock. (page 100)
h. describe strengths and limitations of the Gordon growth model and justify its
selection to value a company's common shares. (page 101)
1. explain the assumptions and justify the selection of the two-stage DOM, the
H-model, the three-stage DDM, or spreadsheet modeling to value a company's
common shares. (page 102)
j. explain the growth phase, transitional phase, and maturity phase of a business.
(page 105)
k. describe terminal value and explain alternative approaches to determining the
terminal value in a DDM. (page 106)
1. calculate and interpret the value of common shares using the two-stage DOM,
the H-model, and the three-stage DDM. (page 107)
m. estimate a required return based on any DDM, including the Gordon growth
model and the H-model. (page 112)
n. explain the use of spreadsheet modeling to forecast dividends and to value
common shares. (page 115)
o. calculate and interpret the sustainable growth rate of a company and
demonstrate the use of DuPont analysis to estimate a company's sustainable
growth rate. (page 116)
p. evaluate whether a stock is overvalued, fairly valued, or undervalued by the
market based on a DDM estimate of value. (page 118)
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PRINTED BY: Xiangzhi Zeng <[email protected]>. Printing is for personal, private use only. No part of this book may be reproduced or transmitted without
publisher's prior permission. Violators will be prosecuted.
Book 3 - Equity
Readings and Learning Outcome Statements
STUDY SESSION 12
The topical coverage corresponds with the following CFA Institute assigned reading:
35. Free Cash Flow Valuation
The candidate should be able to:
a. compare the free cash flow to the firm (FCFF) and free cash flow to equity
(FCFE) approaches to valuation. (page 136)
b. explain the ownership perspective implicit in the FCFE approach. (page 137)
c. explain the appropriate adjustments to net income, earnings before interest and
taxes (EBIT), earnings before interest, taxes, depreciation, and amortization
(EBITDA), and cash flow from operations (CFO) to calculate FCFF and FCFE.
(page 137)
d. calculate FCFF and FCFE. (page 144)
e. describe approaches for forecasting FCFF and FCFE. (page 148)
f. compare the FCFE model and dividend discount models. (page 149)
g. explain how dividends, share repurchases, share issues, and changes in leverage
may affect future FCFF and FCFE. (page 149)
h. evaluate the use of net income and EBITDA as proxies for cash flow in
valuation. (page 149)
1. explain the single-stage (stable-growth), two-stage, and three-stage FCFF and
FCFE models and select and justify the appropriate model given a company's
characteristics. (page 150)
j. estimate a company's value using the appropriate free cash flow model(s).
(page 153)
k. explain the use of sensitivity analysis in FCFF and FCFE valuations. (page 160)
l. describe approaches for calculating the terminal value in a multistage valuation
model. (page 161)
m. evaluate whether a stock is overvalued, fairly valued, or undervalued based on a
free cash flow valuation model. (page 161)
The topical coverage corresponds with the following CFA Institute assigned reading:
36. Market-Based Valuation: Price and Enterprise Value Multiples
The candidate should be able to:
a. distinguish between the method of comparables and the method based on
forecasted fundamentals as approaches to using price multiples in valuation, and
explain economic rationales for each approach. (page 180)
b. calculate and interpret a justified price multiple. (page 182)
c. describe rationales for and possible drawbacks to using alternative price
multiples and dividend yield in valuation. (page 182)
d. calculate and interpret alternative price multiples and dividend yield. (page 182)
e. calculate and interpret underlying earnings, explain methods of normalizing
earnings per share (EPS), and calculate normalized EPS. (page 188)
f. explain and justify the use of earnings yield (EIP). (page 190)
g. describe fundamental factors that influence alternative price multiples and
dividend yield. (page 191)
h. calculate and interpret the justified price-to-earnings ratio (PIE), price-to
book ratio (PIB), and price-to-sales ratio (PIS) for a stock, based on forecasted
fundamentals. (page 191)
1. calculate and interpret a predicted PIE, given a cross-sectional regression
on fundamentals, and explain limitations to the cross-sectional regression
methodology. (page 195)
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Book 3 - Equity
Readings and Learning Outcome Statements
j. evaluate a stock by the method of comparables and explain the importance of
fundamentals in using the method of comparables. (page 197)
k. calculate and interpret the PIE-to-growth ratio (PEG) and explain its use in
relative valuation. (page 200)
I. calculate and explain the use of price multiples in determining terminal value in
a multistage discounted cash flow (DCF) model. (page 201)
m. explain alternative definitions of cash flow used in price and enterprise value
(EV) multiples and describe limitations of each definition. (page 202)
n. calculate and interpret EV multiples and evaluate the use of EV/EBITDA.
(page 204)
o. explain sources of differences in cross-border valuation comparisons. (page 205)
p. describe momentum indicators and their use in valuation. (page 206)
q. explain the use of the arithmetic mean, the harmonic mean, the weighted
harmonic mean, and the median to describe the central tendency of a group of
multiples. (page 207)
r. evaluate whether a stock is overvalued, fairly valued, or undervalued based on
comparisons of multiples. (page 197)
The topical coverage corresponds with the following CFA Institute assigned reading:
37. Residual Income Valuation
The candidate should be able to:
a. calculate and interpret residual income, economic value added, and market value
added. (page 226)
b. describe the uses of residual income models. (page 229)
c. calculate the intrinsic value of a common stock using the residual income model
and compare value recognition in residual income and other present value
models. (page 229)
d. explain fundamental determinants of residual income. (page 232)
e. explain the relation between residual income valuation and the justified price-to
book ratio based on forecasted fundamentals. (page 233)
f. calculate and interpret the intrinsic value of a common stock using single-stage
(constant-growth) and multistage residual income models. (page 233)
g. calculate the implied growth rate in residual income, given the market price-to
book ratio and an estimate of the required rate of return on equity. (page 234)
h. explain continuing residual income and justify an estimate of continuing
residual income at the forecast horizon, given company and industry prospects.
(page 235)
1. compare residual income models to dividend discount and free cash flow
models. (page 240)
j. explain strengths and weaknesses of residual income models and justify the
selection of a residual income model to value a company's common stock.
(page 241)
k. describe accounting issues in applying residual income models. (page 242)
I. evaluate whether a stock is overvalued, fairly valued, or undervalued based on a
residual income model. (page 244)
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publisher's prior permission. Violators will be prosecuted.
Book 3 - Equity
Readings and Learning Outcome Statements
The topical coverage corresponds with the following CFA Institute assigned reading:
38. Private Company Valuation
The candidate should be able to:
a. compare public and private company valuation. (page 258)
b. describe uses of private business valuation and explain applications of greatest
concern to financial analysts. (page 260)
c. explain various definitions of value and demonstrate how different definitions
can lead to different estimates of value. (page 261)
d. explain the income, market, and asset-based approaches to private company
valuation and factors relevant to the selection of each approach. (page 262)
e. explain cash flow estimation issues related to private companies and adjustments
required to estimate normalized earnings. (page 263)
f. calculate the value of a private company using free cash flow, capitalized cash
flow, and/or excess earnings methods. (page 268)
g. explain factors that require adjustment when estimating the discount rate for
private companies. (page 272)
h. compare models used to estimate the required rate of return to private company
equity (for example, the CAPM, the expanded CAPM, and the build-up
approach). (page 272)
1. calculate the value of a private company based on market approach methods and
describe advantages and disadvantages of each method. (page 274)
j. describe the asset-based approach to private company valuation. (page 280)
k. explain and evaluate the effects on private company valuations of discounts and
premiums based on control and marketability. (page 280)
1. describe the role of valuation standards in valuing private companies. (page 284)
©2015 Kaplan, Inc. Page xi
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