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Dubai

CFA Level 2 Equity

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Published in: Accounting
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My notes for the first session on equity. Level 2

Omar / Dubai

4 years of teaching experience

Qualification: CFA Charter holder, Bac of economics

Teaches: Economics, Finance, CFA

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  1. Introduction Introduction 12 year asset management o Equities o Fixed Income 0 REIT CFA charter holder MENA experience ASSET MANAGEMENT
  2. Start With Equity ' Largest Weight in CFA Level 2 ' CFA is generally oriented towards equity ' Most Relevant topic for MENA Investment Proffesional ASSET MANAGEMENT CFA Exam Topic Area Weights Topic Area Ethical and Professional Standards Quantitative Methods Economics Financial Reporting and Analysis Corporate Finance Equity Investments Fixed Income Derivatives Alternative Investments Portfolio Management and Wealth Planning Total Levell Level Il 12 10 20 7 10 10 5 4 7 100 10-15 5-10 5-10 15-20 5-15 15-25 10-20 5-15 5-10 5-10 100 Level Ill 10-15 5-15 5-15 10-20 -5-15 5-15 40-55 100 2
  3. CFA study Plan Best Case Scenario ASSET MANAGEMENT 5 books-5 Month Solving Original Book End of Chapter Questions 1 month Revision + Solving Exams Level 2/3 Have different format 3
  4. Overview On Equity Part Study Session 9 Equity Valuation: Applications & Processes Return Concepts Study Session 10 I ' Industry & Company Analysis Discounted Dividend Valuation Study Session 10 Sessions Session 1 Session 2 Session 3 Session 4 1 Free Cash Flow Valuation Mar_ke! pagd_ Er_ige_ mu_LiQles Residual Income Valuation Private Company Valuation ASSET MANAGEMENT 4
  5. First Session Equity Valuation: Applications & Processes 2 Main concepts Market Price Vs Intrinsic Value ' Intrinsic Value: True Value -5 Complete understanding of asset fundamentals UTOPIA (IVact) Market Price: Current Price ' Intrinsic Value Estimate: Analyst Estimate for IV (IVest) Analysts Job is to Identify Mispriced assets -Y IVansIyst Price IVact - Price Actual Mispricing ASSET MANAGEMENT I Vanalyst — I Vact Valuation Error 5
  6. First Session More Concepts Going Concern Assumption: Continue to operate forever (Basis for all coming valuation method) Liquidation Value: Cease to operate (Assets value net of liabilities) Fair Market Value: Price a willing/well-informed/able investor would trade with another investor with same knowledge Investment Value: Value of the stock to a particular investor (overpaying for seeing specific synergies) ASSET MANAGEMENT
  7. First Session Undervalued/Overvalue d Stocks Uses of Asset Valuation Stock Selection Corporate Reading the Market Is it going to Action increase/decrease value Value Expected Earnings Growth/Expected Return/Comparing to history Valuation of Private Business Undervalued/Overvalue d Stocks ASSET MANAGEMENT Planning & Consulting Portfolio Manage- ment Input of Expected returns in model 7
  8. What should be considered when conducting Industry Analysis Bargaining Power of Suppliers ASSET MANAGEMENT Threat of New Entrants Rivalry Among Existing Competitors Threat of Substitute Products or Services Porter Industry Model Bargaining Power of Buyers The Attractiveness of an Industry (Long term Profitability) Individual Company Strategic Advantage 8
  9. Individual Company Competitive Advantage Walmart, Cost Leadership (Lowest Cost Producer) ASSET MANAGEMENT atlanti Differentiat ion (Unique Products & Services) Focus (Target Segment of Industry using either of previous strategies) 9
  10. Building block of equity valuation Quality Of Accounting Information ' Revenue Recognition and Gains: ' Early revenue recognition: (% of completion/before shipment recognition) ' Reclassifying Non-operating Income (FGB Case) ' Expenses and Losses: ' Inappropriate capitalization of expenses (R&D) ' Delaying recognition of expenses ' Bad debt Reserves (Banks/China/refinancing) Off-balance Financing ' Amortization/Depreciation/discount Rates: Management Discretion 10 ASSET MANAGEMENT
  11. 2 Types of Valuation models Intrinsic Value Absolute Valuation Models Discounting Cash flow (Many Definitions) Asset Value Approach ASSET MANAGEMENT Law of One Price Relative Valuation Models EV/EBITDA 11
  12. Conglomerates (Futtaim/Ghurair/Zamil) Company operates multiple unrelated industries Sum of the Parts Approach Different Business model Different Risk Profile ASSET MANAGEMENT Investors apply mark down Conglomerate Discounts Why? ' Internal Capital Inefficiency 12
  13. Criteria for choosing a valuation approach Criteria Fits the characteristic of the company (Does it pay DVD (DDM)/Significant intangible assets(PB)/QuaIity of Recurring Earnings(PE) ) Quality and availability of input data Is suitable given the purpose of the analysis Example: A company acquiring a majority Stake DCF Model Remember, an analyst can use multiple models ASSET MANAGEMENT DDM Model 13
  14. Return Concepts Holding Period Return Buying EMAAR —Benefit ? The increase in price of an asset plus any cash flow received from that asset divided by the initial price of the asset What if you received Cash flow before end of holding period ? ASSET MANAGEMENT holding period return = r = CFI Cash Flow Yield -1 PO PI _ po Holding period return is usually annualized. Report a one month return of Capital Gain 14
  15. Return Concepts Holding Period Return What is the difference between realized and expected return? What is Required Return? What if the expected return is higher than required return? The mispricing can lead to a return from convergence of price to intrinsic value expected return = required return + 15 ASSET MANAGEMENT
  16. Return Concepts Discount Rate Rate (r) used to find present value of an investment. Value of Discounted Cash Flows CFI CP2 CP3 CFn 2 (R) can be estimated subjectively or use a market determined rate Internal Rate of Return (IRR) The rate that equates the value of the discounted cash flows to current price of security If Markets are efficient ? 16 ASSET MANAGEMENT
  17. Return Concepts IRR If Markets are efficient ? Question? Required Return Emaar is trading at current price of 8 In one year, It is expected to appreciate to 8.7 and distribute a Dividend of 0.5 per share What is the implied IRR? 17 ASSET MANAGEMENT
  18. Return Concepts Equity Risk Premium It is the return in excess of the risk free rate that investors require for holding equity security E(RM) It is usually defined as the required return on a broad equity market index and the risk free rate Steps to determine the (ERP) ' Select an equity Index ' Select a time period ' Calculate mean return of the Index ' Select a proxy Risk free rate ERP= Required return on equity index- RF ASSET MANAGEMENT O Financial Management Pro 1 Beta required return for stockj risk-free return + ßj x (equity risk premium) 18
  19. Return Concepts Equity Risk Premium There are two types of estimates for ERP: Historical Estimates and Forward -looking Estimates Historical Estimates: It is the difference between the mean return of an index and RF over the same time The risk premium will always be lower/higher if we used geometric mean? A weakness of this approach is the assumptions that the mean and variance of return is constant over-time (Stationary) Empirically this not the case, It seems more counter-cyclical 19 ASSET MANAGEMENT
  20. Jan-94 Jun-94 Nov-94 Apr-95 Sep-95 Feb-96 Jul-96 Dec-96 May-97 Oct-97 Mar-98 Aug-98 Jan-99 Jun-99 Nov-99 Apr-OO Sep-OO Feb-Ol Jul-Ol Dec-Ol May-02 Oct-02 Mar-03 Aug-03 Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07 Oct-07 Mar-08 Aug-08 Jan-09 Jun-09 Nov-09 Apr-IO Sep-IO Feb-Il Jul-Il Dec-Il May-12 Oct-12 Mar-13 Aug-13 Jan-14 Jun-14 Nov-14 Apr-15 Sep-15 Feb-16 Jul-16 Dec-16 M y-17
  21. o o o Monte Carlo (MC) Simulation Results 3 Year Investment horizon Equity vs. Fixed income returns for a 100M portfolio (3 years investment) Equity Investment Treasury Investment 106Mn (SAR Portfolio Ending Value (SAR) 130Mn (SAR) Monte Carlo Simulation Results 3Y return With a 75% probability, the portfolio ending value will not be less than SARIOO mn Mean portfolio Ending Value SAR130 mn 0 OO CD m O OO m O OO L.n m I-n m CD O 00 O 00 L.n m Saudi Stock market returns offer an investment return that is 4 times higher than treasury returns MC simulation results main results There is a 75% probability that the portfolio value will maintain its initial Value 130Mn SAR is the expected ending value of initial portfolio investment of 100Mn SAR ASSET MANAGEMENT Confidential I Page 21
  22. Return Concepts Equity Risk Premium Forward-looking Estimates: 1. Survey Estimates Use the consensus of the opinions of a sample of analysts/economists ' Strength: Easy to obtain Weakness: when there is a disparity between the consensus obtained from different groups 22 ASSET MANAGEMENT
  23. Return Concepts Equity Risk Premium Forward-looking Estimates: 2. Gordon Growth Model GGM equity risk premium: 1 Year Forecasted Dividend Yield on Market Index + Long Term Growth — Long Term Bond Yield Weakness: ' Forward looking estimates will changeover time and need to be updated ' Assumption of stable growth rate doesn't fit developing markets equity index price PVrapid(r) + PV transition mature Re is IRR of this equation 23 ASSET MANAGEMENT
  24. Return Concepts Equity Risk Premium Forward-looking Estimates: 3. Macroeconomics Estimate (Supply side) equity risk premium = Il + i J -f- rEg] x (l -l- P Egl —l Y — RF where: = expected inflation 1 rEg = expected real growth in EPS = expected changes in the P/E ratio Y = the expected yield on the index R F = the expected risk-free rate ASSET MANAGEMENT (YTM of 20-year T-bonds) - (YTM of 20-year TIPS) 24
  25. Return Concepts 1. 2. ASSET MANAGEMENT Equity Risk Premium for a particular stock CAPM Model : Estimates the reuired rate of return on equity using the following formula Required return on stock I = RF + (equity risk premium * Beta of i) Regression R-square is between 2-40% Multi-Factor Model: Can have greater explanatory power than the CAPM required return = RF + (risk premium)l + (risk premium)2 + ... + (risk premium)n Risk Premium (i) = (Factor Sensitivity) * (Factor Risk Premium) Factor BETA 25
  26. Return Concepts 1. 2. ASSET MANAGEMENT Multi-Factor Models Fama-French Model: Empiracal evidence shows that some investment strategies generates return higher than predicted by CAPM model Required return on stock I = RF + (equity risk premium * Beta of i) Regression R-square is between 2-40% Multi-Factor Model: Can have greater explanatory power than the CAPM required return = RF + (risk premium)l + (risk premium)2 + ... + (risk premium)n Risk Premium (i) = (Factor Sensitivity) * (Factor Risk Premium) Factor BETA 26

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