[Level 1] Revision Phase with SAPP

Buổi 15 - Equity- Reading 40: Introduction to Industry and Company Analysis & Reading 41: Equity Valuation - Concepts and Basic Tools

READING 40: INTRODUCTION TO INDUSTRY AND COMPANY ANALYSIS

LOS 40.a: Explain uses of industry analysis and the relation of industry
analysis to company analysis.
Question 40.1: Industry rotation is best described as the:
A) adjusting the industry weights in a portfolio based on the current stage of the business cycle.
B) recommended practice of periodically changing the industries that investment analysts are assigned to cover.
C) long-term trend of talented managers and employees exiting mature and declining industries and entering embryonic and growth industries.
Explanation
A is correct. Industry rotation is an active management strategy of overweighting or underweighting industries, compared to their strategic allocation weights, based on the stage of the business cycle.

LOS 40.b: Compare methods by which companies can be grouped, current industry
classification systems, and classify a company, given a description of its activities and
the classification system.
Question 40.2: Auto manufacturers and home builders would most likely be grouped together in an industry classification system based on:
A) type of business activity.
B) sensitivity to business cycles.
C) dividend yields.
Explanation
B is correct. Auto manufacturing and home building are both cyclical industries. An industry classication system based on business cycle sensitivity would be the most likely to group firms from these industries together.


LOS 40.c: Explain the factors that affect the sensitivity of a company to the business
cycle and the uses and limitations of industry and company descriptors such as
“growth,” “defensive,” and “cyclical.”
Question 40.3: Which of the following types of industries is typically characterized by stable performance during both expansions and contractions of the business cycle?
A) Defensive.
B) Cyclical.
C) Growth.
Explanation
A is correct. A defensive industry is typically characterized by stable performance during both expansions and contractions of the business cycle.

Question 40.4:
 A cyclical company is most likely to:
A) have low operating leverage.
B) sell relatively inexpensive products.
C) experience wider-than-average fluctuations in demand.
Explanation
C is correct. Cyclical companies are sensitive to the business cycle, with low product demand during periods of economic contraction and high product demand during periods of economic expansion. They, therefore, experience wider-than-average fluctuations in product demand.

Question 40.5 : Which of the following classifications of firms is least likely to comprise cyclical firms?
A) Housing.
B) Technology.
C) Telecommunications.
Explanation
C is correct. Both technology and housing firms tend to be quite cyclical, that is, their profits are very sensitive to changes in overall growth. The profits of telecommunications firms, on the other hand, are less economically sensitive.


LOS 40.d: Explain how a company’s industry classification can be used to identify a
potential “peer group” for equity valuation.

Question 40.6: Ron Egan, CFA, classifies firms in the transportation industry in peer groups that include airlines and bus operators. Egan learns that one of the airlines, Acme, derives half its revenue from its Acme Bus Lines subsidiary. Egan adds Acme to his peer group for bus operators while continuing to include Acme in his peer group for airlines. Is Egan's treatment of Acme appropriate?
A) Yes.
B) No, because each company should be included in only one peer group.
C) No, because the bus operations are not the company’s principal business activity.
Explanation
A is correct. Peer groups should include comparable companies with similar business activities. An analyst can appropriately include a company in multiple peer groups if the company's business activities are comparable to firms in more than one peer group.

LOS 40.f: Describe the principles of strategic analysis of an industry.

Question 40.7: The threat of substitutes is most likely to be low for a firm that:
A) operates in a fragmented market with little unused capacity.
B) produces a differentiated product with high switching costs.
C) produces a commodity product in an industry with significant unused capacity.
Explanation
B is correct. The threat of competition from substitute products is likely to be low for a firm that produces a differentiated product with high switching costs. Unused capacity and low industry concentration (a fragmented market) tend to intensify rivalry among industry competitors but are not directly related to the threat of substitutes.

LOS 40.g: Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition.

Question 40.8: A company is most likely to earn economic profits if it is operating in an industry characterized by:

A) high industry concentration, high barriers to entry, and low industry capacity.
B) low industry concentration, low barriers to entry, and low industry capacity.
C) low industry concentration, high barriers to entry, and high industry capacity.
Explanation
A is correct. High industry concentration refers to an industry that has a small number of firms, which often leads to less price competition, higher pricing power, and higher return on invested capital. High barriers to entry refer to industries where it is costly for new competitors to enter the industry, which allows companies already in the industry to maintain high profitability and prices. Low industry capacity refers to a situation where demand is greater than supply at current prices, which allows companies to maintain high prices and profits.


LOS 40.h: Describe industry life cycle models, classify an industry as to life cycle stage,
and describe limitations of the life-cycle concept in forecasting industry performance.

Question 40.9: An industry in the growth phase of the industry life cycle is most likely to experience:
A) increasing prices.
B) increasing profitability.
C) intense competition among competitors.
Explanation
B is correct. An industry in the growth stage is usually characterized by increasing profitability, decreasing prices, and a low degree of competition among competitors.

LOS 40.k: Describe the elements that should be covered in a thorough company analysis.

Question 40.10: A firm attempts to gain market share from its competitors by improving its manufacturing efficiency so that it can increase output and reduce the price of its product. This firm's competitive strategy is most accurately described as:
A) an offensive differentiation strategy.
B) an offensive cost leadership strategy.
C) a defensive cost leadership strategy.
Explanation
B is correct. Cost leadership is a competitive strategy in which a firm attempts to become the lowest-cost producer in the industry. This will enable the firm to offer lower prices than its competitors. A differentiation strategy involves making a product distinctive compared to competing products so that customers will be willing to pay a premium price. A competitive strategy is described as defensive if it is used to maintain a firm's market share and offensive if it is used to gain market share.
Schweser note
Porter has identified two important competitive strategies that can be employed by firms within an industry: a cost leadership (low-cost) strategy or a product or service differentiation strategy. According to Porter, a firm must decide to focus on one of these two areas to compete effectively. In a low-cost strategy, the firm seeks to have the lowest costs of production in its industry, offer the lowest prices, and generate enough volume to make a superior return. The strategy can be used defensively to protect market share or offensively to gain market share. If industry competition is intense, pricing can be aggressive or even predatory. In predatory pricing, the firm hopes to drive out competitors and later increase prices. Although there are often laws prohibiting predatory pricing, it can be hard to prove if the firm’s costs are not easily traced to a particular product. A low-cost strategy firm should have managerial incentives that are geared toward improving operating efficiency. In a differentiation strategy, the firm’s products and services should be distinctive in terms of type, quality, or delivery. For success, the firm’s cost of differentiation must be less than the price premium buyers place on product differentiation. The price premium should also be sustainable over time. Successful differentiators will have outstanding marketing research teams and creative personnel.


READING 41: EQUITY VALUATION - CONCEPTS AND BASIC TOOLS

LOS 41.a: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market.

Question 41.1: If an analyst estimates the intrinsic value for a security that is different from its market value, the analyst should most likely take an investment position based on this difference if:
A) the security lacks a liquid market and trades infrequently.
B) many analysts independently evaluate the security.
C) the model used is not highly sensitive to its input values.
Explanation
C is correct. In general, an analyst can be more confident about an estimate of intrinsic value if the model used is not highly sensitive to changes in its inputs. If a large number of analysts follow a security, its market value is more likely to be a reliable estimate of its intrinsic value. A security that does not trade frequently or in a liquid market may remain mispriced for an extended time, and thus may not result in a prot within the investment horizon even if the analyst's estimate of intrinsic value is correct.
Schweser note
The more confident the investor is about the estimated inputs used in the valuation model, the more likely the investor is to take an investment position in a stock that is identified as overvalued or undervalued. Analysts must also consider the sensitivity of a model value to each of its inputs in deciding whether to act on a difference between model values and market prices. If a decrease of one-half percent in the long-term growth rate used in the valuation model would produce an estimated value equal to the market price, an analyst would have to be quite sure of the model’s growth estimate to take a position in the stock based on its estimated value.


LOS 41.b: Describe major categories of equity valuation models
Question 41.2:
 An equity valuation model that values a firm based on the market value of its outstanding debt and equity securities, relative to a firm fundamental, is a(n):
A) market multiple model.
B) enterprise value model.
C) asset-based model.
Explanation
B is correct. An enterprise value model relates a firm's enterprise value (the market value of its outstanding equity and debt securities minus its cash and marketable securities holdings) to its EBITDA, operating earnings, or revenue.
Schweser note
The second type of multiplier model is based on the ratio of enterprise value to either earnings before interest, taxes, depreciation, and amortization (EBITDA) or revenue. Enterprise value is the market value of all a firm’s outstanding securities minus cash and short-term investments. Common stock value can be estimated by subtracting the value of liabilities and preferred stock from an estimate of enterprise value.

 


LOS 41.d: Describe dividend payment chronology

Question 41.3:
 Shareholders selling shares between the ex-dividend date and holder-of-record date:
A) do not receive the dividend, which is paid to the share buyer.
B) do not receive the dividend, which stays with the company.
C) receive the dividend.
Explanation
C is correct. The holder-of-record date is the date on which the shareholders of record are designated to receive the dividend. Shares sold on or after the ex-dividend date are sold without claim to the dividend, even if they are sold prior to the date of record. The dividend would be paid to the holder as of the close of trading on the day prior to the ex-dividend date.

LOS 41.e: Explain the rationale for using present value models to value equity and describe the dividend discount and free-cash-flow-to-equity models

Question 41.4: An analyst gathered the following data about a company:
The historical earnings retention rate of 40% is projected to continue into the future.
The sustainable ROE is 12%.
The stock's beta is 1.2.
The nominal risk-free rate is 6%.
The expected market return is 11%.
If the analyst believes next year's earnings will be $4 per share, what value should be placed on this stock?
A) $22.24.
B) $33.32.
C) $45.45.
Explanation
B is correct.

LOS 41.f: Calculate the intrinsic value of a non-callable, non-convertible preferred
stock.

Question 41.5: Yong Kim, CFA, buys a preferred stock that has a 6% dividend yield (defined as the ratio of the preferred dividend to the market price of the preferred stock). One year later, Kim sells the stock when it is selling at a 5% dividend yield. The preferred stock pays a fixed annual dividend, which Kim received right before selling. What rate of return did Kim realize on his investment?

A) 14%.
B) 20%.
C) 26%.

Explanation
The dividend can be of any size. Suppose it is $1.00.
The purchase price is 1.00 / 0.06 = 16.667.
The sale price is 1.00 / 0.05 = 20. Kim pays 16.667 and receives 20.00 plus a 1.00 dividend one year later.
The rate of return is [(20 + 1)/16.667] − 1 = 26%.


LOS 41.g: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate.

Question 41.6:
 An analyst has determined that the appropriate EV/EBITDA for Rainbow
Company is 10.2. The analyst has also collected the following forecasted information for Rainbow Company:
EBITDA = $22,000,000
Market value of debt = $56,000,000
Cash = $1,500,000
The value of equity for Rainbow Company is closest to:
A) $169 million.
B) $224 million.
C) $281 million.
Explanation
A is correct.
EV = 10.2 × 22,000,000 = $224,400,000
Equity value = EV – Debt + Cash
= 224,400,000 – 56,000,000 + 1,500,000 = $169,900,000


LOS 41.j: Calculate and interpret the following multiples: price to earnings, price to an
estimate of operating cash flow, price to sales, and price to book value.

Question 41.7:
 Jim Boo, CFA, is analyzing Justin Corp., a maker of home appliances. Boo's research provides the following facts:
Justin's stock price is $60 per share.
Expected growth rate of dividends is 5%.
Expected retention ratio is 60%.
Required rate of return is 10%.
Justin's expected price to earnings ratio (P /E ) is closest to:
A) 8.0x.
B) 10.0x.
C) 12.0x
Explanation
A is correct.



LOS 41.g: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two-stage dividend discount
model, as appropriate.

41.8: Assume the Wansch Corporation is expected to pay a dividend of $2.25 per share this year. Sales and profit for Wansch are forecasted to grow at a rate of 20% for two years after that, then grow at 5% per year forever. Dividend and sales growth are expected to be equal. If Wansch's shareholders require a 15% return, the per-share value of Wansch's common stock based on the dividend discount model is closest to:

A) $22.75.
B) $26.00.
C) $28.50.

Explanation



Question 41.9:
 A stock that currently does not pay a dividend is expected to pay its first dividend of $1.00 five years from today. Thereafter, the dividend is expected to grow at an annual rate of 25% for the next three years and then grow at a constant rate of 5% per year thereafter. The required rate of return is 10.3%. The value of the stock today is closest to:
A) $20.65.
B) $22.72.
C) $23.87.
Explanation
A is correct.