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CFA Institute on Equity Valuation

first posted: 2024-02-06 07:05:47.711096

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image credit: CFA institute

Here are some reading notes on the CFA Level 2 Vol 4 2023 course topic is Equity Valuation.

FCFF and FCFE Model Valuation

It opens with valuation based on Free Cashflow.

  • FCF of the Firm: FCFF = NI + NCC + Int (1-TaxRate) - FCInv - WCInv = CFO + Int (1-TaxRate) - FCInv
  • FCF of the Equity: FCFF = NI + NCC - FCInv - WCInv - Net Borrowing

Under GAAP, Int is part of CFO, under IFRS, it can be CFO or CFFIN, but most companies put it in CFO The nonobvious terms are defined as follow:

  • NCC: non-cash charges
  • FC inv: fixed cap invest
  • WC inv: working cap invest

Financials Statements in which the BS changes in working capital amounts do not match the changes reported in the Cashflow Statement are described as "lacking articulation". The main causes for this are a) acquisitions or divestitures and b) consolidation of companies whose statements are computed in a different currency. While a book like How to read financial report is dedicated to explaining how IS, BS and CS "articulate", they do not explain that 75% of the statements as stored in the Compustat database actually do not add up.

"Most analysts prefer to use FCFE rather than dividends to value companies because many companies do not distribute sufficient dividends to justify their valuation."

The value of the firm is computed either from a FCFF growth model with a WACC, or from a FCFE growth model with an equity discount. The equity discount is usually taken as $R_f + \beta (E(R_m)-R_f)$, using a higher equity market total return $E(R_m)$ than the risk free rate $R_f$.

Valuation Ratio

  • P/E is used for comparison it depends much on growth
  • EV/EBITDA has the advantage of being less dependent on capital structure
  • P/B depends on ROE and growth

Residual Income Valuation

This approach is based on applying a cost of capital, it is also used for EVA.

  • EVA = Nopat - C% x TC (C=cost, TC=total capital)
  • Alternatively, it is computed as as a stream paying (ROE-r) . B

Similarly to the problem of articulation of BS with CS, the CFA material mentions that articulation means that Net Income - Dividends is in theory the variation of equity, but that many components add themselves to form a "comprehensive income", and then more.

References:

Other topic: Direct Investment on IDX

Trader advises to go with OCBC Sekuritas, apply for investment permit which is a KSEI at IDX and open the account. This was done in person in Jakarta.