Equity Investments Analysis KASNEB Notes

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CIFA INTERMEDIATE LEVEL

COURSE OUTLINE

GENERAL OBJECTIVE

This paper is intended to equip the candidate with the knowledge, skills and attitudes that will enable him/her to value and analyse equity investments.

LEARNING OUTCOMES

On successful completion of this paper, the candidate should be able to:

  • Undertake industry and company analysis
  • Determine the value of equity securities
  • Apply various models in valuing equity investments
  • Calculate and interpret equity valuation multiples
  • Undertake valuation of private companies
  • Apply the concepts of equity market equilibrium.

CONTENT

Overview of equity markets and structure

  • Structure of the equity market: Financial system and intermediaries
  • Primary and secondary markets for securities; types of orders
  • Trading equity securities
  • Types of equity securities; ordinary shares and preference shares, private versus public
  • Investing in foreign equity securities
  • Risk and return characteristics of different types of equity securities
  • Market value and book value of equity securities
  • Comparison of a company’s cost of equity, accounting rate of return and investors’ required rate of return
  • Equity security and company value.

Fundamental analysis

  • Introduction to fundamental analysis

Overview of company analysis

  • Elements that should be covered in a thorough company analysis; forecasting of the following costs: cost of goods sold, selling general and administrative costs, financing costs, and income taxes
  • Comparing estimated values and market prices; information efficiency and efficient market hypothesis
  • Approaches to balance sheet modeling
  • Growth companies and growth stocks; defensive company and stocks; cyclical companies and stocks; speculative companies and stocks.

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Overview of industry analysis

  • Relationship between industry and company analysis
  • Approaches to grouping companies: Industry classification systems; factors that affect the sensitivity of a company to the business cycle
  • Elements that need to be covered in a thorough industry analysis.
  • Principles of strategic analysis of an industry; competitive forces that shape strategy; effect of competitive forces on prices and costs
  • Effects of barrier to entry, industry concentration, industry capacity, and market share stability on pricing power and return on capital.
  • Product and industry life cycle models; Classification of industry as to life cycle phases (embryonic, growth, shakeout, maturity and decline); limitations of life- cycle concept in forecasting industry performance
  • Comparison of representative industries from various economic sectors
  • Demographic, governmental, social and technological influences on industry growth, profitability and risk

Technical analysis

  • Overview of technical analysis: definition, assumptions, advantages and disadvantages
  • Dow theory: overview ; assumptions; interpretation
  • Elliott wave theory: overview ; assumptions; interpretation
  • Chart types used in technical analysis
  • Trend analysis
  • Technical indicators, rules, momentum indicators, pure price and volume techniques; relationships between market efficiency and technical analysis; application of behavioural finance in technical analysis
  • Forecasting methodology: conditional forecasting, economic forecasting

The equity valuation processes

  • The scope of equity valuation: definitions of value, valuation and intrinsic value, sources of perceived mispricing
  • Valuation and portfolio management
  • Valuation concepts and models: Valuation of speculative stocks; capital asset pricing model, asset valuation, market capitalisation, shareholder value
  • Performing valuations: the financial analyst’s role and responsibilities
  • Alternative to traditional analysis techniques: cash flow return on investment (CFROI)
  • Effects of inflation on the valuation process

Discounted dividend valuation

  • Valuation model of common stock: dividend discount model (DDM)
  • Gordon growth model; underlying assumptions; implied growth rate of dividends using growth model and current share price; calculation and interpretation of present value of growth opportunities; strengths and weaknesses of Gordon model
  • Valuation of non-callable fixed rate perpetual preferred shares
  • Zero-growth model
  • Constant growth model
  • Multiple growth model
  • Multistage dividend discount models: valuing a non-dividend-paying company, first- stage dividend ,H-model, three-stage dividend discount models
  • Finding rates of return for any dividend valuation model
  • Terminal value in a dividend valuation model
  • Determination of whether a stock is overvalued, fairly valued, or undervalued by the market based on a DDM estimate of value
  • The financial determinants of growth rates: sustainable growth rate, dividend growth rate, retention rate, and return on equity (ROE) analysis
  • Financial models and dividends
  • Investment management and DDM

Free cash flow valuation

  • Free cash flow to firm (FCFF) and free cash flow to equity (FCFE) valuation approaches: defining free cash flow, present value of free cash flow, single-stage FCFF and FCFE growth models
  • Appropriate adjustments to net income, earnings before interest and taxes(EBIT),earnings before interest, taxes, depreciation, and amortisation (EBITDA),and cash flow from operations(CFO) to calculate FCFF and FCFE
  • Forecasting free cash flow: computing FCFF from net income(NI), computing FCFF from the statement of cash flows, noncash charges
  • Computing FCFE from FCFF, finding FCFF and FCFE from EBIT or EBITDA: Single- stage, two-stage, and three stage FCFF models; calculating terminal value in a multistage valuation model
  • Uses of sensitivity analysis and scenario analysis in FCFF and FCFE

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Valuation Multiples

  • Overview of valuation multiples: definition and importance; rationale and drawbacks for using valuation multiples

Price multiples

  • Method of comparables and the method based on forecasted fundamentals as approaches to using price multiples in valuation
  • Alternative price multiples and dividend yield in valuation; fundamental factors that influence alternative price multiples and dividend yield
  • Normalised earnings per share(EPS) and its calculation
  • Measures of relative value: Price-to-earnings (P/E) ratio, Price-to-book (P/B) ratio, Price-to-cash flow ratio and Price-to-sales (P/S) ratio
  • Predicted P/E regression

Enterprise value multiples

  • Alternative definition of cash flow
  • Enterprise value multiples and its use in estimating equity value
  • Momentum indicators and their use in valuation
  • Sources of differences in cross boarder valuation comparisons

Residual income valuation

  • Residual income; economic value added(EVA) and market value added(MVA)
  • The residual income valuation model: uses of residual income models; fundamental determinants of residual income ;calculation of intrinsic value of common stock using the residual income model
  • The general residual income model: residual income valuation in relation to other approaches(single-stage residual income valuation, multistage residual income valuation)
  • Comparison of residual income model to divided discount and free cash flow models
  • Determination of whether a stock is overvalued, fairly valued, or undervalued by the market based on a residual income model

Private company valuation

  • Public and private company valuation comparison
  • Reasons for private company valuation
  • Private business valuation: definition of value and how different definitions of value could lead to different estimates of value; income, market, and asset–based

approaches to private companies valuation and factors relevant to the selection of each approach

  • Cash flow related to private company valuation; valuation of a private company using free cash flow, capitalised cash flow and/or excess earnings methods
  • Factors that require adjustment when estimating the discount rate for private companies
  • Valuation of private company using capital asset pricing model (CAPM), market approach methods and asset-based approach
  • Role of valuation standards in valuing private companies

Equity market equilibrium

  • Justification for the short term and long term equilibrium
  • Grinold-Kroner model
  • Yardeni model
  • Tobins q
  • Short term valuation methods
  • Stock market diversity and its measure (entropy)

Emerging issues and trends

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