24/08/15

Business School
Risk and Actuarial Studies

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 5
Equity Valuation and Portfolio Management
Greg Vaughan

This weeks coverage

Bodie et al
Chapter 17
Chapter 18
Chapter 19

Macroeconomic and Industry Analysis

Equity valuation models
Financial statement analysis

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Equity Valuation and Portfolio Management

A.Corporate Accounting Review

B. Equity Valuation
C. Active Equity Management
D. Equity asset class returns

Cash versus accrual accounting

The concept of accrual accounting is to better align
revenue and costs with the accounting period
Profit and Loss Statements (P&L) are on an accrual basis,
as distinct from the Statement of Cash Flows
The quality of accounting is sometimes revealed by
comparing these two statements. This will highlight large
accrual effects which may be genuine or may flag
accounting distortions
The accounting framework provides a statement of past
events which may or may not help to forecast the future

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The Profit and Loss Statement (Simplified)

Operating Revenue
Less Operating Costs
= Earnings Before Interest, Tax, Depreciation and
Amortisation (Gross Profit or EBITDA )
Less Depreciation and Amortisation
= Earnings Before Interest and Tax (Operating Profit or EBIT)
Less Interest
= Pre-tax Profit (EBT)
Less Tax
= Net Profit After Tax (Net Income or NPAT)

The Cash Flow Statement

Cash Flow is conventionally classified into three categories:
1. Operating
2. Financing (borrowing, repayments, capital raising)
3. Investing (capital expenditure which can be a combination
of maintenance and expansion capital expenditure)
Be alert to treatment of interest and dividends
IFRS and AASB

US GAAP

Interest received

Operating or Financing

Operating

Interest paid

Operating or Financing

Operating

Dividends received

Operating or Financing

Operating

Dividends paid

Operating or Financing

Financing

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Extracting Cash flows from the Profit & Loss

Statement and Balance Sheet (simplified)
Sales (P&L)
= Cash from Sales + Receivables (1) Receivables(0)
= Cash from Sales + receivables
Operating Costs (P&L)
= Cash Payments + Payables(1) Payables(0)
+ Inventories(0) Inventories(1)
= Cash Payments + Payables Inventories
Gross Profit (P&L) = Sales(P&L) Operating Costs (P&L)
= Cash from Sales Cash Payments
+ (Receivables + Inventories Payables)
= Cash Gross Profit + (Working Capital)
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Cash Flows to Equity reconciling P&L to Cash

Flow Statement (1)
Free Cash Flow to Equity = NPAT + Depreciation Capital Expenditure
Working Capital

Free Cash Flow to Equity (FCFE) is what dividends are

paid from
Dividend coverage should also be assessed relative to
FCFE. Is a company financing dividends with debt?
FCFE corresponds to Cash Flow from Operations (net of
interest as per US GAAP) less Capital Expenditure
(included with Investing Cash Flows)

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Cash Flows to Equity reconciling P&L to Cash

Flow Statement (2)
FCFE calculated indirectly from the P&L will not always
corresponds to Cash Flow from Operations less Capital
Expenditure
There may be non-operating elements included with NPAT
(eg profit on asset sales, foreign exchange effects)
There may be accrual adjustments other than via working
capital (eg accrual adjustments for interest and tax)
Where there is a significant difference it means that the
accounts are more difficult to interpret
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Motivations for earnings management

Earnings might otherwise fall short of market consensus
risking disappointment shock to share price
Offset disturbance of earnings trend due to non-recurring
events
Recent management change encourages taking out the
garbage and lowering the base for future growth
Earnings risk breaching a debt covenant (eg EBIT/Interest
must exceed 3 x )
Pending IPO requiring positive recent earnings trend
Executive compensation linked to earnings EPS growth
hurdles

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Earnings Management Techniques

Change depreciation assumptions (eg straight-line versus
accelerated, useful life of assets, salvage value)
Capitalization of costs (eg exploration, software
development) so that only their depreciation hits the P&L
Allowance for uncollectible accounts or loans receivable
(eg false sales)
Estimating stage of completion for percentage-ofcompletion contracts (inaccurate matching of revenue and
costs under development contracts)
Estimation of asset write-downs (eg impaired assets)
Exaggeration of restructuring provisions to allow for write
backs
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Signs of companies in trouble (1)

Accounts receivables increase relative to sales suggesting
poor accounts management or in the worst instance false
sales (ie take it, put it in your shop, pay when/if it sells).
The longer accounts remain unpaid, the less likely they will
be recovered in full.
Inventories increase relative to sales suggesting poor stock
control, risk of loss through stock deterioration and possibly
softening demand (ie customers dont want the stock)

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Signs of companies in trouble (1)

Accounts payable increase relative to expenses,
suggesting difficulty in paying expenses, related to difficulty
in collecting receivables (ie cash is tight)
Low capital expenditure (property, plant and equipment)
relative to depreciation suggesting the asset base is not
being replenished

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Financial Ratios Business Performance

Return on Capital Employed (ROCE) is an after tax form of Return on

Assets adjusted for goodwill and non-interest current liabilities, based on
average of beginning and end assets
Economic Value Added = (ROCE WACC) x Capital Employed
Operating Profit is strictly EBIT excluding non-operating income
Free Cash Flow/Dividends is an important coverage ratio to assess
dividend sustainability

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Financial Ratios Quality of Earnings

An alternative to this Cash Realization Ratio is to deduct capex from the

numerator which is then consistent with the denominator being after
depreciation
The asset replacement ratio is intended to detect underinvestment in the
business
Bank covenants on borrowing often refer to minimum levels of interest
cover. A company in breach of covenants will be dealing with banks keen
to redeem or structure its loans. Sometimes EBITDA is the numerator.
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Financial Ratios Valuation

A high PE can occur with cyclically depressed earnings, and a low PE with
cyclically inflated earnings. Comparisons are best made on the basis of
mid-cycle earnings, although often difficult to define
Earnings should also be calendarized for consistency, so that the same
time window (eg next 12 months) is referenced
Australian dividend yields should include franking credits
Enterprise Value/EBITDA is used to compare companies with different
financial leverage
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International comparisons
Accounting methods vary widely internationally (treatment
of goodwill, deferred taxes, pension expense etc) despite
International Financial Reporting Standards (IFRS)
This occurs because IFRS enables companies some
discretion and countries have different historical practices
The US sole objective of profit for shareholders is more
nuanced elsewhere with non-shareholder constituencies
considered
There can be a strong country effect whereby a majority of
stocks in a national market appear cheap or expensive on
a P/E basis compared to other markets
Cash flow based multiples (Free Cash Flow Yield) are less
susceptible to accounting distortion
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Trend Analysis of Ratios

Calculate ratios for a company over several years
Note changes over time for the company
Avoids comparisons across industries
Even Companies within the same industry may be
structurally different (eg different levels of vertical
integration)

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Equity Valuation and Portfolio Management

A. Corporate Accounting Review

B.Equity Valuation
C. Active Equity Management
D. Equity asset class returns

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Simple (one phase) DDM

b is earnings retention (1 payout ratio)

E is next years earnings
k is the equity discount rate eg Rf + B(Rm-Rf)
ROE is return on newly invested equity

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PE to Growth (PEG)
An unreliable rule of thumb
Mathematically the numerator of the PEG is quadratic in
growth (g=bxROE)
The PEG will be maximised when growth is half of the
discount rate (moderate growth)
Not a sensible valuation yardstick

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Price to Book (PB) and the DDM

A companys Price to Book ratio will be high when its return

on newly invested equity exceeds its equity discount rate.
Where this occurs the valuation premium increases with
earnings retention
Note the simplifying assumption that the return on newly
invested equity is the same as the ratio of earnings to
accounting book value not always valid

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Dividend Discount Model

The growth assumption is a product of earnings retention
and the return on newly invested equity
Without any new capital (earnings retention) earnings
would be the same as the previous year
The return on newly invested equity is likely to be different
to the accounting based return on equity (E/B) which is
dependent on past accounting outcomes
Whether or not earnings retention is good for the PE
depends on whether the return on newly invested equity is
higher than the discount rate

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How useful is a Dividend Discount Model ?

The simple one phase model extrapolates the current
assumptions and is highly sensitive to them
Not appropriate where dividend payout is very low or
exceeds free cash flow
The use of DDM for investment requires a thoughtful
approach to the consistency and realism of assumptions
across industries and the market
A more elaborate three phase model will still be dominated
by terminal phase (phase 3) assumptions, but gives more
control to model differences in the early phases
The DDM does provide a framework for understanding the
relativity of PEs due to differences in risk (k) and growth
(ROE).
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Firm Valuation Model

t=

ValueofFirm =
t=1

FCFF t

(1+ WACC )

The current value of equity is obtained by deducting the

value of outstanding debt from the value of the firm
The FCFF is a pre debt cash flow and is independent of
the current capital structure
However some assumption about an optimal capital
structure needs to made to determine the WACC
As with the DDM the cash flows can be summarised in
phases

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Free Cash Flow to the Firm (FCFF)

FCFF = EBIT x (1 Tax rate)
+ Depreciation
- Capital Expenditure
- (Working Capital)
If statements comply with US GAAP (Generally Accepted
Accounting Principles):
FCFF = Cash flow from operations
+ Interest expense x (1 Tax rate)
- Capital Expenditure
FCFE = FCFF Interest expense x (1 Tax rate)
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Forecasting Equity Cash Flows (1)

Forecast
Margins

Forecast Sales

Asset
Turnover

Operating
Expenses

Interest

Forecast
Interest
Rate

Depreciation

Net
Operating
Assets

Tax

Forecast
Leverage

Forecast
Debt

Forecast
P&L

Forecast
Cash Flows

Forecast
Balance Sheet

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Forecasting Equity Cash Flows (2)

Growth expectations are easier to think about in terms of
sales
From there the analyst will consider the balance sheet
required to provide those sales and the expected profit
margin may require new capital raising ultimately
Balance sheet influences interest and depreciation charges
The end result is a cash flow to equity after adjustment for
capital changes
Without this structure it is easy to project cash flows that
are unrealistic
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Weighted Average Cost of Capital (1)

The discount rate for FCFF valuation is
WACC = k(E/(E+D))+ i(1-t)(D/(E+D))
where k is cost of equity, i is cost of debt dependent on
corporate credit rating, t is corporate tax. Equity (E) and
debt (D) are at market values.
Cost of equity exceeds cost of debt so other things being
equal, WACC decreases with higher debt proportion
However cost of equity and cost of debt both increase with
leverage (higher debt proportion)
Hence WACC decreases to a point with increased debt,
then increases as the capital structure becomes riskier and
higher costs of equity and debt offset the debt effect

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FCFF versus Dividend Discount Model

Where the capital structure of the company is changing, for
example debt is being reduced, the trajectory of dividends
over time can be distorted.
FCFF is independent of the capital structure.
In some cases dividend payments can be at unsustainably
high payout ratios, or alternatively very low payout ratios
making growth difficult to forecast. FCFF simply reflects
firm profitability and is easier to forecast in these situations.
Even where annual forecasts are made for a few years, the
valuation is still critically sensitive to terminal value
assumptions

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DDM versus FCFF (similar structure)

DDM

FCFF

Gross Cash Flow

NPAT

EBIT(1-t)

Asset base

Equity

Equity + Debt

Net Cash Flow

Dividend

Free Cash Flow to Firm

=EBIT(1-t)+Dep-Capex -WC

Discount factor

Cost of Equity

WACC

Retention

(NPAT Dividend)/NPAT

((Capex Dep)+WC)/
EBIT(1-t)

Return on retention

ROE=NPAT/Equity

ROA=EBIT(1-t)/(Equity+Debt)

NetCashFlow
DiscountFactor Growth
NetCashFlow = (1 Retention) GrossCashFlow

Valuation =

Growth = Retention Return _ on _ Retention

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Discounted Cash Flow valuation models

Three classic phases of Discounted Cash Flow models (eg
Dividend Discount)
First phase is high growth (capital expenditure will exceed
depreciation, payout is low)
Second phase is transition during which growth declines
(capital expenditure will approach depreciation, payout
improves)
Third phase is steady state where growth is stable (capital
expenditure in line with depreciation, payout normal) and
likely more in line with the industry, or the economy
generally
The use of a one phase model assumes steady state not
always appropriate, especially for growth companies
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Realistic Growth Assumptions

Growth = Retention Return _ on _ Retention
This equation defines internally sustainable growth (ie
without the need for additional capital raising)
The asset base is only expanded by retention of part of the
cash flow, unless new capital is issued
If the return dynamics are stable, growth can only occur by
expanding the asset base
The return on retention should relate to new investment
which may be more or less profitable than prior investment
In reality return dynamics may not be stable, and growth
can be affected, at least in the short-term, by changing
profitability (eg better margins)
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Decomposition of ROE
ROE =

Net Profit

Pretax Profit
(1)

Tax
Burden

Pretax Profit

(2)

Interest
Burden

Sales

EBIT
x

EBIT

(3)

Sales

Assets
x

(4)

Assets
Equity

(5)

Margin x Turnover x Leverage

When forecasting ROE or ROA and trending towards stable

assumptions, a margin/turnover decomposition can be useful
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Industry Structure - Porters five determinants of

competition (what drives ROE)
Barriers to entry (low tech versus high tech, patents,
economies of scale, network effects)
Rivalry between Existing Competitors (fragmented
industries)
Pressure from Substitute Products (eg digital download
versus CD)
Bargaining Power of Buyers (Woolworths and milk, brand
strength, switching costs)
Bargaining Power of Suppliers (iron ore)

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Valuing using comparables

Which publicly traded companies are most similar?
Typically firms in same industry
Need to make allowance for finer differences in risk and
growth opportunities to narrow the selection of comparables
Porter analysis can help
Companies with multiple divisions can be tricky
More robust if a number of different ratios are used eg P/E,
P/B, EV/EBIT
Are earnings of company or comparables distorted by any
transient or cyclical factors?

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What to use where in the Australian market

Banks are commonly compared on Price to Book and
Gross Dividend Yield including franking
Resource stocks are compared on Price to Cashflow and
Price to NPV (a DCF valuation of the company)
A-REITS (property trusts) are compared on Price to NTA
(net tangible assets) and AFFO yield (Adjusted Funds from
Operations, related to rental yield)
Infrastructure vehicles are sometimes compared on
Enterprise Value/EBITDA because of leverage variation
Other industrial companies are compared on the basis of
P/Es and Gross Dividend Yields
Importantly investors in practice dont compare all stocks
on the one measure, because our market is so disparate
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Other valuation issues

Should a loss making division be included in a PE
based comparable valuation?
Maybe not because if earnings were expected to stay
negative it would not be in operation
Sum of parts approach facilitates adjustment for assets
in development, not yet contributing to earnings
Private companies trade at discounts to public
companies because of lack of marketability
In a takeover situation there may be a premium for
control due to leverage adjustment, better use of cash
flows, and realisable synergies

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How useful is valuation?

Its not about point estimates, but reasonable ranges
Sensitivity analysis is very important most results are very
flexible
Even where a valuation estimate is firmly within a narrow
range, price may not revert to value anytime soon.
Prices may move further away from fair value before they
return
In practice value is often sanitised with other characteristics
(eg quality, earnings or price momentum). This avoids
catching the falling knife.

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Equity Valuation and Portfolio Management

A. Corporate Accounting Review

B. Equity Valuation

C.Active Equity Management

D. Equity asset class returns

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A Factor Approach to Active Equity Management

Alpha can be estimated directly by identifying alpha factors, and the
exposure of each stock to those factors
The composite alpha is simply a sum of products of alpha exposures and
expected alpha factor returns
The expected alpha factor returns might be time varying or in some
applications fairly constant
Example with Value and Momentum as factors

E( k ) = X Vk E(rV ) + X kM E(rM )
V

In practice the factor exposures, (eg X k ) are calibrated so the weighted

exposure of the market index is zero.
Alpha factors may be included in the risk structure but they tend to be
chosen for stability so unnecessary (they wont explain much risk!)
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Risk is addressed via the risk factor structure

Recall

= X F X"+
nxn

nxf

fxf

fxn

nxn

The covariance matrix builds from stock risk factor exposures (X), the
covariance of risk factor returns (F) and the diagonal matrix of stock
idiosynchratic variances ().
A simple, but effective, risk factor structure might be classification by
broad sector (eg mining, financial, defensive, cyclical) and small size. So
factor exposures are simply 0,1.
A small mining stock in this structure would have factor exposures of
(1,0,0,0,1). A large bank would be (0,1,0,0,0).
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Risk is addressed via the factor structure

The variance of active returns relative to benchmark is simply:

2
A

= (WP WB )" (WP WB )

And the portfolio alpha, assuming calibration for benchmark alpha of

zero, is

P = WP!
The utility function for optimisation is simply

"1%
Utility = P $ ' A2
#2&
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Examining portfolio optimality (1)

The portfolio is optimised when the marginal contributions to utility of the
weight vector are zero:
dU
=0
dWP

= (WP WB )

Stock specific estimates of alpha, the LHS vector, can be plotted

against the marginal contributions to risk, (WP WB )
In theory these stock coordinates would conform to a line passing
through the origin if the portfolio was optimal
In practice this is a scatter plot because of practical constraints
turnover, long-only, sector neutrality

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Examining portfolio optimality (2)

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Portfolio optimisation in practice

A range of constraints apply in practice (eg active weights within +/-4%)
A standard portfolio optimisation converts risk to a common currency
This can lead to portfolios that are seemingly OK in aggregate but have
some significant tilts within
In practice the structure of the portfolio can be managed explicitly along
other dimensions as well as composite active risk (eg small cap exposure
within +/- 5% of benchmark)
This can be implemented by a scheme of quadratic penalties which
augment the Utility function
The risk of these extra dimensions may already be reflected in the risk
factor structure
The flexibility of being able to tweak sensitivity over time is to respond to
time varying risk (eg heightened risk in the mining sector because of
recent sharp slowing in the Chinese economy)

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Portfolio construction without optimisation

More commonly portfolio construction is not determined by an
optimisation process
A less mathematical approach is equally valid
An competent portfolio manager can adjust key risk exposures (eg
sector weightings and size exposures) without using optimisation
Preferences about stocks can be implemented by arbitrarily adjusting
portfolio weights without being explicit about alpha estimation
A mathematically elegant process that gets the sign of the alpha wrong
is clearly inferior to an experienced back of the envelope
Mathematical portfolio construction is very useful, and advantageous,
in the right hands

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Value Investment Style

Value investing is not well defined. It may refer to:
1. Low P/E investing investing in stocks with low P/E
ratios which can often lead to significant sectoral
biases (eg overweight cyclical stocks)
2. Contrarian investing investing in stocks perceived by
the market as having problems (eg tough competition,
compressed margins), and where the market may have
exaggerated the risks.
3. High Yield focusing on stocks that have high dividend
yields (including franking) and where the dividend is
likely to be sustained or increased

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What goes wrong with Value Investing (1)

The cheap valuation is misinterpreted
Sometimes poor valuation method
Referring to the DDM, the risk may be genuinely
elevated warranting the high discount rate
Or the growth prospects are genuinely impaired
because the profitability of new investment (retained
earnings) is structurally low

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What goes wrong with Value Investing (2)

Overestimating turnaround potential
When a management with a reputation for brilliance
tackles a business with a reputation for bad economics, it
is the reputation of the business that remains intact
- Warren Buffett

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Growth Investing (1)

Growth investors focus on the trajectory of earnings, past
and forecast, and are less sensitive to valuation
May also incorporate earnings revision and price
momentum
Strong growth, if it occurs, can compensate for paying a
high price (eg high P/E, low yield) IF stronger than the
market expects
Emphasize growing industries with strong sales growth
Easy proposition for client investors because of confusion
of growth with return
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Growth Investing (2)

The risk for growth investors is that the blue sky vision they
share with the market does not materialize.
Growth disappoints and valuations get rerated downwards.
Technically a company with a low payout should exhibit
stronger growth than a high payout company, but that does
not necessarily correlate with a higher return.
A correctly priced growth stock will have a high P/E and
simply return the equity discount rate

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Preferred environment for value or growth

Value investing has fewer problems when the economic
environment is generally positive and growth in earnings
is abundant
Value is then picking the cheapest of healthy situations,
whereas growth investors are at risk of paying too much
for the highest growth opportunities
Conversely growth investing does well when earnings
growth is relatively scarce and cheap stocks can be very
treacherous
Growth is then picking the most economically robust of
a conservatively priced market
Arguably the Australian market is too narrow for the US
approach of growth/value separation.
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Equity Valuation and Portfolio Management

A. Corporate Accounting Review

B. Equity Valuation
C. Active Equity Management

D.Equity asset class returns

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Equities and Inflation (1)

Inflation distorts the accounting earnings of companies
depreciation tends to be lower than the cost of asset
replacement, stale inventory valuation can inflate profits
Inflation lifts discount rates and other things being equal
lowers DCF valuations
The valuation effect is less straightforward because
depending on the source of inflation, profits may
increase (demand pull) or margins may compress (costpush)
Inflation generally increases uncertainty in the financial
environment so risk premiums may increase
Dividends tend to keep pace with inflation, even if return
outcomes are less reliable in the short-term
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Equities and Inflation (1)

Inflation distorts the accounting earnings of companies
depreciation tends to be lower than the cost of asset
replacement, stale inventory valuation can inflate profits
Inflation lifts discount rates and other things being equal
lowers DCF valuations
The valuation effect is less straightforward because
depending on the source of inflation, profits may
increase (demand pull) or margins may compress (costpush)
Inflation generally increases uncertainty in the financial
environment so risk premiums may increase
Dividends tend to keep pace with inflation, even if return
outcomes are less reliable in the short-term
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Equities and Inflation (2)

Referring to the DDM, equities may not be an effective
hedge against inflation in the short-term because (Wilcox):
Inflation is not accurately anticipated by investors,
necessitating adverse price adjustments. Unanticipated
inflation provokes counter-cyclical monetary policy
A rise in inflation tends to affect discount rates more
directly than growth expectations due to money illusion
the application of nominal discount rates to real cash
flows
Rising inflation affects the risk premium on stocks due to
greater uncertainty.

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Equities and Inflation (3)

Stock Returns and Inflation: A Long-Horizon Perspective
Boudoukh and Richardson (1993)
Looked at correlation over horizons of 1 and 5 years
US 1802-1990; UK 1820-1988
Consistent with other studies, no correlation over 1 year
horizon
However statistically significant positive correlation for 5
year horizons (incl for 1914-1990 sub-period)
So more confidence in inflation hedge once horizon
moves beyond the short-term

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Valuing the stock market in aggregate the Fed

model (now discredited)
EY / Bond =

E / P y + ERP b ROE
=
y
(1 b)y

= 1+

ERP b(ROE y)
(1 b)y

Popularised in Fed commentary in the late 1990s but

always suspect
Through the 1980s and 1990s earnings yield and bond
yields moved closely together
The relationship broke down in the early 2000s
In theory the ratio will vary over time depending on
changing Equity Risk Premum (ERP) and growth
prospects (ROE) variations not mispricing

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Cyclically Adjusted P/E ratio (CAPE) - better

Developed by Robert Shiller (Yale)

Cyclically Adjusted Earnings are an average of the past ten years of
earnings for the market, inflation adjusted

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Next Week
Fundamentals of Credit Analysis (Chapter 5 Gootkind)
Read thoroughly
Bodie, Kane and Marcus
Chapter 14. General background. Know different
instruments.
Chapter 15 . Read full chapter with particular emphasis on
15.3 to 15.5
Chapter 16. Study full chapter carefully. Understand
duration, convexity and immunization well.

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Next Week
Student guest contributions:
Group H: BKM 15.3 + 15.4
Fundamentals of Credit Analysis Sections 2 and 3
Group I: Fundamentals of Credit Analysis Section 5

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