Reading 51: Investment Analysis

The first part talks about different real estate investments like Raw Land, Warehouses, Office Apartments, Residential Apartments, Shopping Malls and Hotels/Motels. The most illiquid is Raw Land, followed by Shopping Centers and Hotels.

The most passive investment is a Warehouse because of the long term lease involved.

Next, we learn how to calculate Cash Flow after Taxes (CFAT) and Equity Reversion After Taxes (ERAT) and then use these along with the NPV and IRR formula to make real estate investment decisions.

For the calculation of CFAT, we use the following steps-

1. Calculate taxes payable using: (Net Operating Income (NOI)- Interest(I)- Depreciation (D))* Marginal Income Tax Rate = Taxes Payable.

2. Then, NOI- Annual Debt Service- Tax payable (from Step 1) = CFAT

ERAT is calculated for the last year of the investment, after it is sold. The recaptured depreciation needs to be calculated-

• When net selling price (Selling price- selling expenses) > Original cost, then the recaptured depr= total accumulated depreciation. (Since the investment has appreciated, the entire depr. needs to be recaptured).
• If Net Selling Price < Original cost, then Recaptured Depr < Accumulated depr. and is calculated as (Net selling price- Adjusted Book Value = Realisd Capital Gain).

The format for arriving at the total tax on realized gain is-

Sales Price
-Expenses associated with Sales
======
= Net Sales price
– Book Value (Original Value- Accum. Depr)
=========
Realized Gain

Now, the tax on realized gain= Tax on Recaptured Depr + Tax on Long term capital gain.

So, calculate the tax on recaptured depr= Tax rate on Recap. Depr * The recap. depr (as illustrated above).

Then, the long term capital gain that should be taxed at the Capital gains tax rate- Realized gain- Recaptured depr. . Then calculate the tax on long term capital gain by using the tax rate for capital gains * total long term capital gain.

ERAT is calculates as Sales price- Sales costs- total mortgage payments- Total taxes (incl. recap. depr. tax and long term cap. gains tax).

The third part of the reading is about NPV and IRR. Same old stuff! For calculating them, use CFAT for the cash flows, and also discount ERAT for the terminal year. The discount rate that is used is called the after-tax discount rate. In case of a conflict, go for NPV (like we learned before).

THE END!

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Tags: RealEstate Valuation, CFA, Finance, Equity Valuation, Business

Reading 50: Economic Value Added (EVA)

1. EVA= NOPAT- $WACC, where NOPAT= EBIT(1-t) and $WACC=WACC*Invested Capital

2. EVA Spread=EVA/Invested Capital= Return on Capital (ROC)+ WACC % rate, where ROC= NOPAT/Invested Capital

3. Firm’s enterprise Value (EV)= Invested Capital +MVA, where MVA= PV of future EVA. If we assume EVA to be a perpetuity (for simplicity), then EV= IC+ (EVA/WACC) . Here, MVA is also referred to as Net Present Value (NPV).

Note: EV also equals= Equity+ Debt- Cash and investments (as learned previously) and MVA= MV of long term debt and equity- BV of long term debt and equity

3a. Five ways to increase EVA- Increase revenue, decrease operating expenses, Decr. WACC, decrease invested Capital, and take advantage of positive NPV projects (in which case, the positive cash inflow will be more than the investment in capital).

4. CFROI (Cash Flow Return on Investment) Ratio can b calculated using the following steps-

a. computer life of the assets (N)

b. Compute gross CF (PMT)

c. compute gross cash investment  (PV)

d. compute non-depreciable assets (FV)

e. solve for CFROI (I/Y)

5. We can use EVA for stock selection using a graph where the Y-axis= EVA spread (ROC-WACC) and the X-axis= Ratio of MV of invested capital (enterprise value)/replacement cost of invested capital. This ratio is crudely equal to P/B. Stocks lying above the curve are underpriced and stocks lying below the curve are overpriced.

Reading 49: Residual Income Valuation

1. Residual income= Net Income- Cost of Equity (Equity rate*total equity outstanding)=E-(r*Equity)=(ROE-r)*BV(t-1)

2. Economic Value Added (EVA)= NOPAT -$WACC, where NOPAT= EBIT(1-t)

$WACC= WACC* Invested Capital

Invested capital= Change in NWC+ Net fixed Assets = BV of Long term debt + BV of Equity

Some adjustments that need to be made:

• R&D costs should be capitalized instead of expensed
• Strategic investments that will earn returns in the future should not be charged.
• Amortization needs to be added back to the earnings; goodwill should be capitalized and depreciation should be added back to the invested capital.
• only cash taxes should be considered. Deferred taxes are eliminated.
• Operating leases are treated as capital leases

3. Market Value Added (MVA)= MV of long term debt and MV of long term equity – BV of long term debt and equity (same as invested capital acc. to #2; a.k.a total capital)

4. Single state residual income model:

V0=B0+[(ROE-r)/(r-g)] *B0  (From the equation P0/B0=(ROE-g)/(k-g)

5. Bt=B(t-1)+Et-Dt. The residual income model assumes this clear surplus relationship.

6. In general, V0=B0+ Present Value of (Future residual income). For multi stage RI model, first forecast RI over the short term growth period, and then make some simplifying assumptions over the long term period. The  RI over the long term period is assumed to have constant growth and ROE and is known as continual RI.

The value of continual RI in year (T-1) is RI(t)/(1+r-w) where w= persistance factor and ranges betn. 0 and 1.

Alternate method of finding continual RI= P(t)-B(t) and then discount this back to the present.

I Have Moved

to Blogger for the time being. I wanted to try Google Adsense. I might come back again if I see that it’s useless.

Edit: Will remain there anyway. I want to give Blogger a try after the newly introduced OpenID system.

This is my new blog. Please update your links and feeds. Thanks!

Edit: I’m back! I feel lazy updating the Blogger blog. Very typical of me.

Reading 46: Dividend Discount Valuation

I have been reading this chapter since yesterday and I’ve made some good progress with the material here- mainly due to the fact that most of it is not new to me. We have been re introduced to concepts such as DDM, Gordon Growth Model (GGM) etc.

The Curriculum has a very nice summary at the end. So, I don’t think I’ll be putting up any notes for this reading. It will be a waste of time for me. I have another eight pages left to read. Also, the chapter end problems.

I’ll post some formulae tomorrow. That’s all.

I need to complete Equity Valuation by 12/31. That’s another 250 pages to read. As of now, it sounds a little daunting, but I think I should be able to manage it, provided I don’t get drunk and waste time. Moreover, I need to remind myself to study.

Reading 43: Valuation in Emerging Markets

After about 4 days, I finally picked up my book again. Blame it on my Graduation excitement. Yeah- I’m an MBA now. 🙂

I did this reading from Schweser after seeing that the official reading is too long. I might come back to the official curriculum in case I’m having trouble solving questions. I worked out the concept checkers at the end of Schweser material and they are really good.

Main Concepts:

1. The real valuation approach discounts real cash flows at the real rate of return, while the nominal valuation approach discounts nominal cash flows at the nominal rate of return. But the value of the firm using both the methods will be almost the same.

2. Cash flow forecasting for real markets tends to be challenging because of the high inflationary environment. Three issues require particular attention-

• Income taxes are based on nominal earnings; so an estimation of nominal EBITA is required.
• Real NWC and Nominal NWC are not the same. We need to divide Nominal NWC by the inflation rate to arrive at the Real NWC. The change in the nominal NWC captures the flow effect, but the holding loss in real NWC is ignored. So, in an inflationary environment, the investment in Real NWC increases and the real FCF decreases.
• Nominal capital expenditures are difficult to calculate by simply calculating sales and related expenditures because of the high inflation. So, we need to calculate the real sales, real capital expenditures, real EBITDA and depreciation on a real basis.

3. FCF= NOPLAT+ Depreciation- Change in NWC- Change in Net Capital Expenditure

NOPLAT= EBITA- Taxes

4. Steps for valuing a firm in an emerging economy on a real and nominal basis are-

• Calculate the revenue, EBITDA, Invested Capital and EBITA on a real basis.

[Note: Invested Capital= Net PPE (End)+ NWC;

Net PPE (End)= Net PPE (Beg)- Depreciation +Capital Expenditure.

Depreciation is calculated by Dividing the Beg. PPE by the number of years.]

• Calculate the Revenue, EBITDA, Depreciation and EBITA on a nominal basis.
• Calculate the real NOPLAT
• Calculate FCF on a real and nominal basis.
• Estimate firm value in both real and nominal terms by discounting the real and nominal FCF at the real WACC and the nominal WACC. The nominal WACC is not the same every year because of the inflation rate. (1+nominal rate)= (1+real rate)(1+ inflation rate)

Effect on Financial Ratios: Generally the ratios in real terms are accurate and the ratios in nominal terms are incorrectly estimated. ROIC (Return on Investment Capital= NOPLAT/Beg. Invested Capital) is overstated in nominal terms. NWC/Revenue is correctly states in both real and nominal terms. Ratio of PPE/Revenue is generally understated in nominal terms.

5. There are two ways of incorporating emerging market risk in the valuation process- a. Adjusting the cash flows in a scenario basis b. Adjusting the discount rate by adding a country risk premium. Adjusting the cash flows has more support because of the following reasons-

• Country risks are diversiable
• Companies respond differently to country risk. (All companies might not use the same country risk premium. So it’s better to adjust the individual cash flows).
• There is no systematic method to calculate a country risk premium.
• When managers have to discuss emerging market risks and their effects on cash flow in scenarios, they gain more insights than they would get from country risk premium.

6. Calculation of WACC should follow these guidelines-

Risk free rate= 10 yr US Govt Bond Yield + Difference in inflation betn. both the countries

Beta= Industry beta from a globally diversified market index.

Market Risk Premium should be between 4.5-5.5% (long term average risk premium on a global market index)

Pre-tax cost of debt= Local Risk free rate + US credit spread on comparable debt

Marginal Tax Rate- Only taxes that apply to the interest expense should be included. Other taxes or credits should be modeled directly in the cash flows.

Some assumptions that are used while calculating WACC-

We have adopted the perspective of an international investor who has a diversified portfolio. As long as international investors have access to local investment opportunities, local prices will be based on an international cost of capital. Another assumption is that most country risks are diversifiable from the perspective of a global investor. We therefore need no addl. risk premium in the cost of capital when discounting cash flows.

7. When using the Country Risk Premium approach, we should keep the following points in mind-

Do not simply use the sovereign risk premium which is the difference betn. the long term US bond yield and a dollar denominated local bond’s yield with the same maturity. This is because this difference will reasonably approximate the country risk premium only if the cash flows of the corporation being valued moves closely in line with the payments on government bonds.

We need to understand estimates from different analyst sources because the underlying assumptions will vary. For eg- A high country risk premium might be used along with a very high growth rate and a low country risk premium might be used with a low growth rate. So the final value might still be the same.

We should not set the country risk premium too high. One way to do this is to compare the expected return using the CAPM Model with the historical real rate of return.

Reading 42: Industry Analysis

This reading was quite interesting. I used Schweser as a study guide to get a gist of the entire chapter and then used the Curriculum for my main reading. Took me about 2.5 hours, I guess. I worked out the concept checkers at the end of Schweser 2007.

Main points:

The model of an Industry Analysis should include-

Industry Classification

External Factors

Demand analysis

Supply Analysis

Profitability

International Competition and Markets (Not covered by the LOS).

Let’s discuss each of these parts in details now-

I. Industry Classification– Can be done either by Industry Life Cycle or Business Life Cycle.

a. Industry Life Cycle– Pioneer, Growth, Mature and Decline are the 4 stages.

Pioneer- 7/10 start up businesses fail to survive.

Growth- Even when the economy is doing poorly, growth industries can experience positive profits. They prosper independent of the business cycle.

Mature- Within a mature industry, there might be a couple of growth companies. They can achieve this by acquisition or improved quality/service.

Decline- Remaining participants consolidate. The better managed survivors anticipate this fate and avoid it by using cash flow to diversify into promising industries.

b. Business Life Cycle– Industry classified as either-

Growth -above normal rate of expansion and independent of the business cycle. Eg- Computer Software Industry).

Defensive- Stable performance throughout the business cycle. Egs- Utilities, food, cigarettes and beer industry and govt. contractors.

Cyclical- Produce discretionary products, the consumption of which depends upon the economic optimism. Egs- Auto industry, heavy equipment and machine tool producers. Certain cyclical firms experience earnings patterns that do not correlate well against the general economy, but trend against other economic variables. (Brokerage firms use the stock prices as their base and agricultural firms that are related to the crop price cycle).

Problems with Industry Classification-

a. Self-deception- placing all not all companies in a mature industry are mature companies.

II. External Factors-

There are five external factors:

Technology- For pioneer industries, the question is will the market accept the innovation? For mature industries, the question is- will the industry face obsolescence from competing technologies?

Govt- New regulations, changes etc. can impact an industry either positively or negatively. For eg- Tobacco industry facing problems.

Social changes- Either due to fashion or lifestyle changes. Fashion changes are of a shorter duration and more unpredictable. Eg- women’s clothing line. Lifestyle changes take place over long periods of time and easier to determine.

Demographics- Studying the vital stats of population, such as distribution, age and income. They are easier to identify and track compared to other external factors, but disagreement occures in sizing up its impact on relevant industries.

Foreign influences-Foreign policies and restrictions.

III. Demand Analysis- Can be achieved in three ways-

a. Top Down Economic Analysis when the revenues correlate strongly to one economic statistic.

b. Industry Life cycle- Categorizing the industry within its life cycle position.

c. External Factors

Customer Study- Segmenting the customers into submarkets (based on user type, type of business, geographic, sex, age etc.) to study a smaller number of factors that contribute to demand.

For established industries, the analyst should contact long time customers to figure what drives demand in each submarket.

For growth industries- the analyst considers new outlets for the industry’s products.

Untested industries- We need to determine if the new industry fulfills a need that exists and isn’t being met by another industry. Assuming a new is verified, analysts typically forecast new industry sales based on the experience of a similar industry.

Input/Output Analysis- A rising consumption of the finished product boosts demand for industries supplying the intermediate steps.

IV. Supply Analysis-

In the long term, it is appreopriate to assume that supply will equal demand. In the short term, there can be a shortfall in supply in case of –

a. Capacity intensive industries where the lead time is high, or

b. When capacity is diabled due to natural disasters.

The analyst should obtain data on the aggregate size of the potential supply of output from a given industry- incl. foreign industry- and compare this with projected demand for the industry output (called capital utilization data, which is equal to the total capacity divided by the total demand).

V. Profitability, Pricing and the Industry Study

A supply/demand forecast gives an indication of future profitability. A projected oversupply will retard investment since it augurs lower prices.

Factors contributing to pricing include:

a. Product segmentation- Most industries effectively segment their product offerings by brand name, reputation, or service, even when the products are quite similar.

b. Degree of industry concentration

c. Ease of industry entry

d. Price changes in key supply inputs

****

I left out the pages that talked about International Competition and Markets because it’s not covered by any of the relevant LOSs.

Inclusion of Short Summaries

I have been forgetting lots of important formulae and concepts. I wonder if there is any point studying like this. During Level-I prep, I used to forget stuff the first time around also. I need a couple of revisions before everything sinks in. I had made lots of flashcards for level I.

Since I’m already writing here, I will try to even write short summaries for each reading. I got this idea from Matt’s blog. I think what he does makes a lot of sense. It’s much easier to read a summary instead of reading tons and tons of material from the Curriculum.

I’m about to start reading Industry Analysis and should be able to complete it sometime today. So stay tuned 🙂

Reading 41 (Competitive Strategy) Completed

I got done with the second part of this reading that focused on Differentiation, Cost Focus and Differentiation Strategy. There is a brief explanation on Stuck in the middle firms and on the requirements of sustaining competitive advantage. Lastly, the reading finishes off with the importance of generic strategy in strategic planning of a firm.

I’m thinking of jotting down some main points henceforth, because it will help me in quick revision later.

Differentiation– Focus on only some needs of the buyer and fulfill them. Charge a premium for it, but try to maintain cost parity by reducing cost in all areas that do not affect differentiation. There can be a number of firms pursuing this strategy, as long as they choose different buyer attributes.

Focus– Can be either cost focus or differentiation focus. If a focuser’s target segment is not different from other segments, then the focus strategy will not succeed.

Stuck in the middle– No competitive advantage. It basically means trying to follow all the strategies at the same time. It can be successful only if the competitors are also stuck in the middle or if the industry structure is highly favorable. In the long run, if other competitors shift towards a generic strategy, then the firm that is stuck in the middle can lose its profitability.

Three conditions under which a firm can simultaneously achieve both cost leadership and differentiation are-

1. Competitors stuck in the middle- Might be a temporary situation because the competitors might shift to a generic strategy in the future, leaving your firm in a soup.

2. Product innovation- It should not be easily copied by the competitors.

3. Cost is strongly affected by share or interrelationships- If market share dictates the cost structure, then this will help. Also unmatched relationships between industries that one firm can exploit and other cannot will also help.

Sustainability– We need to focus on the risks of the different strategies and try to eliminate them as much as possible.

Generic Strategies and the Strategic Planning Process– STPs must always be dictated by the generic strategy of the firm because it helps in building competitive advantage. Categorization of business units into build, hold or invest is a method of resource allocation and not a stategy.

Similarly, market share per se is not important competitively; competitive advantage is.

***

So this completes Reading 41. I’m done with the end of chapter problems too. The ones in the Curriculum were quite challenging and I got only 2 correct. 😦 The ones in Schweser (concept checkers) were easier.
Also, in some industries, market leaders do not enjoy the best performance because industry structure does not reward leadership. The pursuit of leadership sometimes diverts attention from achieving and maintaining competitive advantage. So, smaller firms that are not market leaders might become more profitable because of their competitive advantage.

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Tags: CFA, Equity Valuation, Thoughts, Finance

Done Reading 40 from the CFAI Textbook

Finally achieved this task after not studying for a week. It probably took me around 2-3 hours to re-read everything in Reading 40 from the CFAI Curriculum and the Schweser notes combined. I had to go back to Schweser for some parts because the details in the Curriculum really bogged me down 😦

The main trouble that I had was with the first LOS that differentiates the accounting rules betn IASB, GAAP and other accounting rules all over the world for common accounting treatments of Consolidation, Business Combination, Joint Ventures etc. The curriculum has more details on this part. I would say, for everything else, Schweser does a good job.

Important Formulae:

1. P/E (intrinsic)= Tangible P/E + Franchise P/E

= 1/r + (FF*G)

Franchise Factor (FF)= (ROE-r)/(ROE*r)

Growth Factor(G)= g/(g-r)

It is necessary for retention ratio (b)>0 and ROE>r for a company to have franchise P/E.

2.  P/E= 1/(real interest rate+ (1-inflation flow through rate)(inflation rate))

Even if inflation rate is high, if all of it  is absorbed by the inflation flow through rate, then the P/E is unaffected. Otherwise, the higher the inflation rate, the lower the P/E ratio.

The entire chapter spans more than 60 pages in the Official Curriculum…it’s long and boring. I’m yet to work out the chapter end problems. I’ll make sure that I do it tomorrow and complete Reading 41 too.

Reading 41 talks about Competitive Strategy and should be more interesting to read, because I just completed a course in management that’s based on this stuff.

I need to remind myself to stop wasting time on my other blog, Time and Again, and by watching Heroes (my new found fascination).

Hope all of you are studying hard. Please keep commenting and motivating me too. I think I’m falling behind. 😦

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Tags: CFA, Equity Valuation, Thoughts