corporate valuation vietnam - final1.pdf

Corporate Valuation
J-P. Pichard-Stamford
jpps@gmx.fr
Corporate Valuation

Books suggestions
⚫ Arnold G., The Handbook of Corporate Finance, Prentice Hall, 2004
⚫ Damodaran A., Corporate Finance : Theory and Practice (2nd Edition), Willey
series in finance, 2001
⚫ Damodaran A., The Dark Side of Valuation : Valuing Young, Distressed, and
Complex Businesses (2nd Edition), 2009
⚫ De Pamphilis D., Mergers, Acquisitions and other Restructuring Activities,
Academic Press, 2001
⚫ Fernandez P., “ Valuation of brands and intellectual capital”, working paper, 2001
⚫ Fernandez P., Carabias J.M., “96 Common Errors in Company Valuations”,
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=895151, 2006
⚫ Koller T., Goedhart M., Wessels D., Valuation : Measuring and Managing the
Value of Companies, 5th Edition (Wiley Finance), 2010
⚫ Palepu K.G., Healy P.M., Peek E., Business Analysis and Valuation, South
Western Editions, 2008
⚫ Thauvron A., Évaluation d’entreprises, Economica, 2005
⚫ Vernimmen (2005), Finance d’entreprise, Dalloz

Cosmetic
Cosmetic difference can be use of different word to refer to the
same items. A few examples are as follows, international term
followed by U.S. counterpart
3

Contents
Introduction
1. The Cost of Capital
2. Income Models
3. Method of Comparables
4. Residual Income Model
5. The Value of Control

Introduction
⚫ 1. A straightforward view of economic transformations : the new
shareholders view (transformating beliefs and transformating
behaviors)
⚫ 2. Understand the problem of valuation
5

1. Shareholders revolution around the 80’s
➢ The ultimate test of management is becoming value creation : top quality CEOs
deliver consistently superior shareholder returns : Maximising good growth
and eliminating bad growth is essential to achieving the governing objective
➢ Why : ERISA (earning-retirement-income-security-art) (1974) and the 73
petroleum choc for advanced economies
➢ Importance of Core Business : diversified risk managed directly by
shareholders
➢ Corporate Governance is the rule in US in the 80’s and Europe in the 90’s
➢ Finance rules the world !
Focusing on
Shareholder
Value
Transforming
Beliefs
Transforming
Behaviour
Transforming
Management
Performance
Derivatives
Forex
Financial Transactions
Real Economy
Total
699,0
384,4
39,4
32,3
1 155,0
Total World
Transations
1012$ (2002)

➢Change organisation structure to ensure clarity of accountability for value
e.g, accountability for market segments
➢Change organisation structure to ensure new learning about new sources of
competitive advantage
➢Delegate accountability for value as close as possible to the customer and
competition
➢Avoid excessive centralisation
Single
Business
Market-Based
Segmentation
Multiple
Product
Specialist
Value Centres
Value Centres
for Products
and Customer
Relationships
Move from managing the value of the Group as one business,
to managing the value of the Group through multiple “value centres”
Organisation
Structure
Organization structure

Why it is important for You ?
8
-100
0
100
200
300
400
500
600
700
800
1978 1982 1986 1990 1994 1998 2002 2006
Flux privˇs
Flux publics
Donnˇes IIF
Origine des flux (USD milliards)
Asian Crisis
Private vs Public funds (USD Bilions)

Why it is important for Corporate Valuation ?
Core Business : Dupont Analysis & Return on Equity
Leverage
Turnover
Asset
Total
Margin
Profit
Equity
Assets
Total
Assets
Total
Sales
Sales
Income
Net
Equity
Income
Net
=
ROE


=


=
Minoring Book Value and Boosting Value Creation

Focus on the Fixed-Asset Turnover Ratio
This ratio measures how effectively a company manages its fixed assets to
generate revenue.
Net sales
Average fixed assets
Fixed asset
turnover
ratio
=
Dell generates nearly two times more sales dollars for
each dollar invested in fixed assets than Apple does.
= 15.4
$57,420
($2,409 + $1,993)/2
= 26
$24,006
($1,832 + $1,281)/2
2007 2006 2007 2006
Property, plant, and
equipment (net) 2,409
$ 1,993
$ 1,832
$ 1,281
$
Net sales 57,420 24,006
Dell Apple

2. Valuation Concepts
There is no single value. Value can change dramatically depending on the
answers to these questions :
➢ a. Fair Value and Values
➢ b. Some Valuation “Myths”
➢ c. What is being valued and Why is it being valued ?
➢ d. What is the appropriate premise of value ?
➢ e. How will you value it ?
➢ f. What discounts or premiums are appropriate ?
➢ g. Byers and sellers value perspectives ?
➢ h. Valuation – The Big Picture

Fair Value
a. Fair Value and Values
= Investment Value
Source: IFRS 3 Appendix A
Purchase Price
Willing buyer & willing seller
Hypothetical buyer concept
Stand-alone valuation
“Fair Value is the amount for which an
asset could be exchanged, or a liability
settled between knowledgeable, willing
parties in an arm’s length transaction.“
• Synergistic or strategic value
• Willing buyer is not a hypothetical
marketplace buyer but rather is a
particular buyer with specific
expectations about future events,
cost of capital, taxation, and other
issues
• The seller is compelled to sell
• The buyer may be a willing buyer, but
the seller must sell unwillingly
Liquidation Value (net realisable value)
including Forced Sale
For example

b. Some Valuation “Myths”
1. Since valuation models are quantitative, valuation is objective
• models are quantitative, inputs are subjective
2. A well-researched, well-done model is timeless
• values will change as new information is revealed
3. A good valuation provides a precise estimate of value
• a valuation by necessity involves many assumptions
4. The more quantitative a model, the better the valuation
• the quality of a valuation will be directly proportional to the time spent
in collecting the data and in understanding the firm being valued
5. The market is generally wrong
• the presumption should be that the market is correct and that it is up
to the analyst to prove their valuation offers a better estimate
Source : A. Damodaran, “Investment Valuation : Tools and Techniques for Determining The
Value of Any Asset”

➢Transactions
➢Buying/Selling/Merging
➢Privatization
➢Strategic internal decisions
➢ESOPs
➢Tax
➢Estate, gift & inheritance taxes
➢Estate recapitalizations
➢Charitable contributions
➢Buy/Sell agreements
➢Litigation
➢Dissolution of corporation or
partnership
➢Review/critique of another
expert’s report
➢Damages
➢Lost profits
➢Marital dissolution
➢Certain assets
➢Interest-bearing debt
➢Preferred stock
➢Common stock
➢Controlling
interest
➢Non-controlling
interest
➢Enterprise Value
Why is it being
valued?
What is being
valued?
c. What is being valued and Why is it being
valued ?
➢Cash flow generating
ability
➢Risks associated with
achieving the projected
cash flows
➢Value of the net assets
owned by the business
➢Right to vote and
influence business
decisions
➢Marketability of
ownership position
Special
consideration ?

⚫ Value as a going concern
⚫ Assets in continued use as a
viable business enterprise
⚫ Value as an assemblage of assets
(reorganization)
⚫ Include assets not in current use
in the production of income and
not as a going-concern business
enterprise
⚫ Value as an orderly disposition
⚫ Assets sold individually with
normal exposure to the market
⚫ Value as a forced liquidation
⚫ Assets sold individually with
limited or no exposure to the
market
d. What is the appropriate premise of value ?
1. The vertical scale establishes the conditions
under which the asset is being disposed, such
as liquidation, orderly disposal, reorganization
or going concern.
2. The horizontal scale measures time in monthly
increments.
CONTEXT + TIME = VALUE
Source : CONSOR Intellectual Asset Management

e. How will you value it ?
2 (principal) Principles of Valuation
⚫ Book Value
⚫ Depreciated value of assets minus
outstanding liabilities
⚫ Adjusted net asset value method
adjusts all individual assets and
liabilities to market value.
⚫ Liquidation Value
⚫ Amount that would be raised if all
assets were sold independently
⚫ Market Value (P)
⚫ Value according to market price
of outstanding stock
⚫ Relative valuation estimates the
value of an asset by looking at
the pricing of 'comparable' assets
relative to a common variable like
earnings, cashflows, book value
or sales.
⚫ Intrinsic Value (V) = Income
approach
⚫ NPV of future cash flows
(discounted at investors’ required
rate of return)
Looks Backward Looks Forwards
Market Value > Intrinsic Value > Book Value > Liquidation Value

17
Book value Vs. Market value
⚫ Market value is oriented to value in use or economic value : the ability to
generate future cash flows.
⚫ Shareholders and managers are concerned about the market value of
their stock, so their focus is on a market value driven balance sheet.
⚫ Equity and asset “Market Values” are usually higher than their “Book
Values”. Market values of assets and liabilities are driven by economic
value factors. Seldom are they the same.
Importance of the life cycle and the owner strategy
Example : Google
• Market value (Jan 25 2011) $197 billion (price per share x number of shares)
• Book value (Sep 30 2010) $43 billion

⚫ Earnings
Assume WACC =
(10 % x 1 500) + (10% x 500) = 10%
(1 500 + 500)
Discounted earnings =
Net Profit/Discount rate
150/10 % = 1 500
Income statement (1)
First case : BV = MV
⚫ BV
Assets 2 000
Oustanding liabilities - 500
BV 1 500
HERE, ROE = COST OF CAPITAL
(NO DESTRUCTION OR VALUE CREATED)
Current Assets
Fixed Assets
800
1 200
Liabilities
Equities
500
1 500
Sales
Expenses
Net
earnings
1 650
(1500)
150

⚫ Earnings
Assume WACC = 10%
(10 % x 1 543) + (10% x 500) = 10%
(1 543 + 500)
Discounted earnings =
Net Profit/Discount rate
193/10 % = 1 930
Income statement (2)
Second case: BV < MV
⚫ BV
Assets 2 043
Oustanding liabilities - 500
BV 1 543
MV = BV + VALUE CREATED (ABNORMAL EARNINGS)
Current Assets
Fixed Assets
843
1 200
Liabilities
Equities
500
1 543
Becareful : “Profits” record income
and expenses at the time of sales,
not when the cash exchanges
actually occur
“Profits” do not consider changes in
working capital
Sales
Expenses
Net earnings
1 650
(1457)
193

BV Problem : failing to overlook Intangible
Assets and, moreover, intellectual capital
✓Intangible Assets : valuable holdings that have no physical form
➢ Gap between book values per share and stock prices : physical assets account
for about 15% of total assets and high tech firms feature even wider gap
➢ Traditional methods fail to capture rapid growth
➢ Difficulty identifying and measuring value of :
✓Brands (Coca-Cola)
✓Distribution networks (Walmart)
✓R&D expenditures (IBM)
Watch accounting rules

Comparing US
GAAP and IFRSs :
Intangible Assets
21

‘Intellectual capital is the group of knowledge assets that are attributed to an
organisation and most significantly contribute to an improved competitive position of
this organisation by adding value to defined key stakeholders’ (Marr and Schiuma,
2001)
Classification of intellectual capital
Human capital Relational (customer) capital
Know-how
Education
Vocational qualification
Work-related knowledge
Work-related competencies Entrepreneurial
elan, innovativeness, proactive and reactive
abilities, changeability
Brands
Customers
Customer loyalty
Company names
Distribution channels
Business collaborations
Licensing agreements
Favourable contracts
Franchising agreements
Organisational (structural) capital
Intellectual property
Patents
Copyrights
Trade secrets
Trademarks
Infrastructure assets
Management philosophy
Corporate culture
Management processes
Information systems
Networking systems
Financial relations

Valuation issues across the life cycle
Value
Temps
Creation Rapid
expansion
High
Growth
Mature
Growth
Decline
MV BV

f. What discounts or premiums are
appropriate?
Value may be influenced by extenuating factors
⚫ Premiums
⚫ Control
⚫ Strategic acquisition
⚫ Discounts
⚫ Lack of control
⚫ Lack of marketability
⚫ Key person
⚫ Known (or potential) environmental liability
⚫ Pending litigation
⚫ Concentration of customer base or supplier base

g. Byers and sellers value perspectives ?
25
The seller’s management team maintained that the brand’s value (including the
intellectual capital) under its management was 337 million. The buyer’s management team
would use the company’s assets and the brand in a different way from the seller’s
management team.
It is also obvious that the value of the shares and the brand would be different for another
prospective buyer. Finally, the shares were sold for 1.05 billion euros.
Value for whom and
for what purpose ?

LA BECOB
750 millions francs
Economic Value
450 millions
Relational Capital
300 millions
Crony (French) Capitalism
No Due Diligence !
Bernard Henri Levy François Pinault
Source : Nicolas Beau et Olivier Toscer, 2006
Mysterious purposes ?

h. Valuation – The Big Picture

Accounting and Financial Analysis
⚫ Always be suspicious : Accounting analysis : Studying transactions and
events judging how accounting policies affect financial statements, and adjusting
FS to better reflect the underlying economics and make them more amenable to
analysis.
⚫ Warren’s position : Financial analysis is the use of financial statements to
analyze a company’s financial position and performance and to assess future
financial performance, and includes an examination of profitability, risk, and cash
flows (sources and uses of funds). It will answer questions regarding a firm’s past,
present and future situation, including
⚫ How profitable is the company?
⚫ Did earnings meet analyst forecasts?
⚫ How strong is the company’s financial position?
⚫ What are [the company’s] sources of profitability?
⚫ Does the company have the resources to succeed and grow?
⚫ Does the company have resources to invest in new projects?
⚫ What is the company’s future earning power?

Conduct of the Valuation Engagement
— Ownership Information
⚫ The valuation analyst should obtain and analyze sufficient ownership
information in order to:
⚫ Understand any other matters that may affect value, such as:
⚫ For business interests
▪ Shareholder agreements
▪ Partnership agreements
▪ Operating agreements
▪ Voting trust agreements
▪ Buy-sell agreements
▪ Loan covenants
▪ Restrictions and other contractual obligations
⚫ For intangible assets
▪ Licensing agreements
▪ Sublicense agreements
▪ Nondisclosure agreements
▪ Development rights
▪ Commercialization or exploitation rights
▪ Other obligations
29

Chapter 1.
The Cost of Capital

The Cost of Capital
⚫ 1.1. Once Again : What is Value Creation ?
⚫ 1.2. The Cost of Equity : the Capital Asset Pricing Model
⚫ 1.3. Estimating CAPM items
⚫ 1.4. Evolution from the CAPM
31

32
⚫ A Risk must be rewarded
⚫ For usual claimants the hurdle rate
on invested capital must exceed
the return on capital employed
1.1.Once Again : What is Value
Creation ?

Capital Employed and Invested Capital ?
33
Current Assets :
-Cash
-Marketable Securities
-Accounts & Notes Receivable
-Inventory
Fixed Assets :
-Equipment
-Building
-Land
Assets
Liabilities &
Stockholder’s Equity
Current Liabilities :
-Accounts Payable
-Notes Payable
-Accrued Tax
Long-term Liabilities :
-Long-term bank loans
-Bonds
Stockholder’s Equity :
Balance Sheet
Current
Working Capital
Fixed Assets
Net cash
[Long-term bank loans
- cash]
Equity
Operational
(Capital employed)
Financing
(Invested Capital)
Value Added when
Return on Capital Employed > (Hurdle) Return on invested Capital

Capital Employed Capital Invested
Fixed Assets
Current
Working Capital
Equity
Net cash
Equity Cost
ke
Debt Cost
kd
Hurdle Rate on Invested Capital
= the Cost of Capital
Value is created when a company is able to get a
return on its assets higher than its WACC

The weighted average cost of capital (WACC)
⚫ The weighted average cost of capital is the market-based weighted average of
the after-tax cost of debt and cost of equity :
WACC = D/V*kd (1 − Tm) + E/V*ke
⚫ where
⚫ D/V = Target level of debt to enterprise value using market-based values
⚫ E/V = Target level of equity to enterprise value using market-based values
⚫ kd = Cost of debt
⚫ ke = Cost of equity
⚫ Tm = Company’s marginal income tax rate
35

Value Creation
Value Created = (Return On Investment - Cost of Capital) X Capital employed
Dependent Upon :
⚫ Cost of Capital Spread (see chapter 1)
⚫ Duration of Spread
⚫ Amount of Capital Employed
Also called :
✓ Residual income
✓ Abnormal earnings (assuming that over the long term the firm is expected to earn
its cost of capital (from all sources), any earnings in excess of the cost of capital
can be termed abnormal earnings.
One example of several competing commercial implementations is Economic Value
Added (EVA®) trademarked by Stern Stewart & Company.
EVA® = NOPAT – (C% х TC)
NOPAT is the firm’s net operating profit after taxes,
C% is the cost of capital and
TC is total capital.

An example of residual income
⚫ Axis Manufacturing Company (AMC) has total assets of €2,000,000 financed 50% with debt
and 50% with equity capital. WACC = 12%. Net income for AMC can be determined as
follows :
EBIT € 200,000
Less : Interest Expense 70,000
Pre-Tax Income € 130,000
Income Tax Expense 39,000
Net Income € 91,000
⚫ What is it’s residual income ? One approach is to compute the cost of capital (in terms of
currency), which we term a capital charge, and subtract this from net income, as follows :
Capital Charge = Capital х Cost of Capital in %
Cost of Capital = €2,000,000 х 12% = € 240,000
Net Income € 91,000
Capital Charge 240,000
Residual Income € (149,000)
AMC did not earn enough to cover the cost of capital.
As a result, it has negative residual income.

ROCE (capital employed) and WACC
38
Over the last 15 years, the largest European listed groups, registered spreads between
0.1% (1994) and 3.9% (2006). In a nutshell, this is not impossible but very hard, even for
the most powerful groups, to achieve!

The Length of Value Creation Period
39
Some companies have peak ROCEs that are very high but offer little
sustainability. Other companies have peak ROCEs near the cost of capital but
can generate excess returns over an extremely long period

⚫ In its early life, the company was a
pioneer in the computer chips (random
access memory-RAM). Intel created value
for nearly 10 years, but the Japanese
government made RAM a high priority,
and companies such as NEC and Fujitsu
began to flood the market with similar
chips at lower prices.
⚫ The price competition was so intense that
it nearly drove Intel out of business.
⚫ With a financial infusion from IBM, the
company reinvented itself, creating the new
“brains” of the personal computer. Through
an informal partnership with Microsoft, Intel
led the personal-computer microprocessor
market.
⚫ By the late 1990s, facing increased
competition and a general downturn in
technology, Intel could no longer post the
enormous ROCEs of the mid-1990s.
Intel has twice sustained high ROCEs over
the last 30 years
ROCE
measured
as three-
year rolling
average

Historically, Johnson & Johnson has earned strong returns on capital through its patented
pharmaceuticals and branded consumer products lines, such as Tylenol and Johnson’s Baby
Shampoo. Through strong brands and capable distribution, J&J has been able to maintain a
price premium, even in the face of new entrants and alternative products.
41
ROCE
measured
as three-
year rolling
average
Over the past 30 years, Johnson & Johnson has maintained an ROIC
greater than the cost of capital during the entire period

Determinants of the Length of Value Creation Period
Size of the firm
Success usually makes
a firm larger. As firms
become larger, it
becomes much more
difficult for them to
maintain high growth
rates
On an other hand, it is
difficult for competitors to
overcome the economies
of scale
Current growth rate
While past growth is not
always a reliable
indicator of future
growth, there is a
correlation between
current growth and future
growth. Thus, a firm
growing at 30% currently
probably has higher
growth and a longer
expected growth period
than one growing 10% a
year now
Barriers to entry and
differential advantages
The question of how long
growth will last and how
high it will be can
therefore be framed as a
question about what the
barriers to entry are, how
long they will stay up and
how strong they will
remain.

Determinants of the Length of Value Creation Period
Boeing Home Depot Infosoft
Firm
Size/Market
Size
Firm has the dominant
market share of a slow-
growing market
Firm has dominant market
share of domestic market,
but is entering new
businesses and new
markets (overseas)
Firm is a small firm in a
market that is
experiencing significant
growth
Current
Excess
Returns
Firm is earning less than its
cost of capital, and has
done so for last 5 years
Firm is earning
substantially more than its
cost of capital
Firm is earning
significant excess
returns
Competitive
Advantages
Huge capital requirements
and technological barriers
to new entrants.
Management record over
the last few years has been
poor
Significant economies of
scale are used to establish
cost advantages over
rivals. Has a management
team that is focused on
growth and efficiency
Has both a good product
and good software
engineers. Competitive
advantage is likely to be
limited, since employees
can be hired away, and
competitors are
extremely aggressive
Length of
High Growth
period
10 years 10 years 5 years
10 years, entirely because
of competitive advantages
and barriers to entry
10 years; it will be difficult
for competitors to
overcome the economies
of scale
5 years. In spite of the
firm’s small size, the
competitive nature of
this market and the lack
of barriers to competition
make us conservative

44
The Tree of Value Creation
Increase the cash
flows from existing
assets to the firm
Increase the expected
growth rate in these
cash flows
Extend the length
of the high
growth period
Reduce the cost of
capital
increasing after-tax earnings from assets
in place
reducing reinvestment needs in net
capital expenditures or working capital
Changing the financial mix
Improving the return on capital on those
reinvestments
Increasing the rate of reinvestment in the
firm
Reducing the operating risk in
investments/assets
Changing the financial composition
Build on existing competitive advantage
Find new competitive advantage
Brand name
Legal Protection
Cost advantage

Ways of Increasing Cash Flows from Assets in Place
45
Value Enhancement through Growth
Revenues
*Operating Margin
= EBIT
- Taxe Rate * EBIT
= EBIT*(1 - t)
+ Depreciation
- Capital Expenditures
- Chg in Working Capital
= FCF
Divest Assets that have
negative EBIT
Reduce Tax Rate :
moving income to lower
tax locales
Live off past over-
investment
Bette inventory
Management and tighter
Credit policies
Reinvestment Rate
*Return on Capital
= Expected Growth Rate
More efficient operations
and cost cutting :
Higher Margins
Reinvest more in
projects
Increase operating
margins
Do Acquisitions
Increase Capital
Turnover Ratio

Reducing Cost of Capital
46
Changing
product
characteristics
Make product or service
less discretionary to
customers
Changing financing mix
Reduce operating
leverage
Outsourcing
Flexible wage contracts
and cost structure
Match debt to assets,
reducing default risk
More effective
advertising
Swaps Derivatives Hybrids
Cost of Equity (E/(D+E)) + Pre-tax Cost of Debt (D/(D+E)) = Cost of capital
Corporate
Governance
Mecanisms

Shareholder
value
creation
ROCE
Economic
Profit
Margin
Capital
Turnover
Sales
Targets
cogs/
sales
Development
Cost/Sales
Inventory
Turnover
Capacity
Utilization
Cash
Turnover
Order Size
Customer Mix
Sales/Account
Deficit Rates
Cost per Delivery
Maintenance cost
New product
development time
Indirect/Direct
Labor
Customer
Complaints
Downtime
Accounts Payable
Time
Accounts
Receivable Time
CEO Corporate/Divisional Functional Departments & Teams
Organizational perspective :
Linking Value Drivers to Performance Targets

48
The Balanced Scorecard
balances the financial
perspective with the
organisational, customer and
innovation perspectives
which are crucial for the
future of an organisation
Organizational perspective : the Balanced Scorecard

F
I
N
A
N
C
I
A
L
F1 Return on Capital Employed
F2 Cash Flow
F3 Profitability
F4 Lowest Cost
F5 Profitable Growth
F6 Manage risk
Strategic Objectives
Financially
Strong
* ROCE
* Cash Flow
* Net Margin
* Full cost per gallon delivered to customer
* Volume growth rate Vs. industry
* Risk index
Strategic Measures
C O
U M
S E
T R
-
C1 Continually delight the targeted consumer
C2 Improve dealer/distributor profitability
* Share of segment in key markets
* Mystery shopper rating
* Dealer/distributor margin on gasoline
* Dealer/distributor survey
Delight the
Consumer
Win-Win
Relationship
I1 Marketing
1. Innovative products and services
2. Dealer/distributor quality
I2 Manufacturing
1. Lower manufacturing costs
2. Improve hardware and performance
I3 Supply, Trading, Logistics
1. Reducing delivered cost
2. Trading organization
3. Inventory management
I4 Improve health, safety, and environmental performance
I5 Quality
I
N
T
E
R
N
A
L
* Non-gasoline revenue and margin per square foot
* Dealer/distributor acceptance rate of new programs
* Dealer/distributor quality ratings
* ROCE on refinery
* Total expenses (per gallon) Vs. competition
* Profitability index
* Yield index
Delivered cost per gallon .Vs. competitors
* Trading margin
* Inventory level compared to plan & to output rate
* Number of incidents
* Days away from work
* Quality index
L
E &
A G
R R
N O
I W
N T
G H
L1 Organization Involvement
L2 Core competencies and skills
L3 Access to strategic information
* Employee survey
* Strategic competing (?) availability
* Strategic information availability
Safe and
Reliable
Competitive
Supplier
Good Neighbor
On Spec
On time
Motivated and
Prepared
Balanced Scorecard for Mobil N. American Marketing & Refining
Example

1.2. The Cost of Equity :
the Capital Asset Pricing Model
⚫ The capital asset pricing model is the oldest and still the most widely used
model for risk in the investment world.
⚫ It is derived in four steps :
1. Uses variance as a measure of risk
2. Specifies that a portion of variance can be diversified away, and that is only the
non-diversifiable portion that is rewarded.
3. Measures the non-diversifiable risk with beta, which is standardized around
one.
4. Translates beta into expected return -
⚫ Expected Return = Riskfree rate + Beta * Risk Premium

The Capital Asset Pricing Model
⚫ A. Risk and Reward under CAPM Assumptions
⚫ B. Portfolio Theory and Risk
⚫ C. CAPM : from the Capital Market Line to the Security Market
line
51

A. Risk and Reward under CAPM
Assumptions
⚫ 2 sets of Assumptions :
[1] Perfect market :
⚫ Frictionless, and perfect information
⚫ No imperfections like tax, regulations, restrictions to short selling
⚫ All assets are publicly traded and perfectly divisible
⚫ Perfect competition – everyone is a price-taker
[2] Investors :
⚫ Same one-period horizon
⚫ Rational, and maximize expected utility over a mean-variance space
⚫ Homogenous beliefs
According to Efficient
Market Hypothesis
All available information is integrated in price :
Market prices reflect values and information
accurately and quickly (E. Fama, 1966)
➢Price change is practically continuous
➢Price changes follow random patterns. Future
share prices are unpredictable (Brownian Motion)

Random walk
N = 1
N = 3
N = 1000
up
down
T
ln(S)
Long term
tendency Lognormal
return (ST)
A simplified representation of hazard permits to describe an asset by its
Expected Return and its Standard Deviation

Risk/Reward tradeoff definition
⚫ Return : ⚫ Expected Return :
Rt = Dt + (Pt – Pt-1)
Pt-1
Ert+1 =
EDt+1 + (EPt+1 – Pt)
Pt
Dt : Dividend in t
Pt-1 : Price in t – 1
Pt : Price in t
Pt - Pt-1 : Capital gain between
t-1 and t
E : Expected value
EDt+1 : Dividend expected value in t+1
EPt+1 : Expected price in t+1
Ept+1 - Pt : Expected capital gain between t-1 and t
Expected Reward Definition
 

=

=
n
1
s
s
i,
s return
p

Small Risk
Huge Risk
Risk Definition
Financial translation :
disparity between actual
and expected returns
The first symbol is the symbol for “danger”, while
the second is the symbol for “opportunity”,
making risk a mix of danger and opportunity.

Risk = Standard Deviation
: confidence interval at 68 %
: confidence interval at 95 %
: confidence interval at 99,7 %

 =
=
−

=
−

=
n
i
i
n
i
i R
R
n
R
R
n
R
V
1
_
1
2
_
²
²
1
)
(
1
)
(
SD (R)

Source : Mandelbroot, 2009
Assets Returns Real volatility
Brownian
Motion

B. Portfolio Theory and Risk
58
Conventional Wisdom circa 1950
"Once you attain competency, diversification is undesirable. One or two, or at
most three or four, securities should be bought. Competent investors will never
be satisfied beating the averages by a few small percentage points.“
Gerald M. Loeb “The Battle for Investment Survival”, 1935
➢Analyze securities one by one
➢Focus on picking winners
➢Concentrate holdings to maximize returns
➢Broad diversification is considered undesirable
1952, Diversification and Portfolio Risk
➢Harry Markowitz (Nobel Prize in Economics, 1990)
➢Diversification reduces risk.
➢Assets evaluated not by individual characteristics but by their effect
on a portfolio
➢An optimal portfolio can be constructed to maximize return for a
given standard deviation
Paradigm revolution

a. Distinction between rewarded and
unrewarded risk
⚫ Total risk = Systematic risk + Unsystematic risk
⚫ Firm Specific Risk or Unsystematic risk is risk that influences a single
company and can be diversified away in a diversified portfolio.
⚫ Systematic risk or Market Risk is risk that influences a large number of
assets and cannot be diversified away.
⚫ The marginal investor is assumed to hold a “diversified” portfolio.
Thus, only market risk will be rewarded and priced.
Rewarded Risk Unrewarded Risk

⚫ Two-Security Portfolio Return :
ERP : X ERA + (1 – X) ERB
X : Equity A weight
(1 – X) : Equity B weight
⚫ Two-Security Portfolio Risk
²RP = X² ²RA + (1 – X)²²RB + [2X (1 – X) RARB RA,RB]
RP =  ²RP
b. Diversification principle
B
A
AB
AB
COV


 =
[+ 1.0 >  > -1.0]

⚫ The relationship ‘risk-expected return’ depends on the correlation
coefficient : [-1.0 <  < +1.0]
⚫ The smaller the correlation, the greater the potential benefits from
diversification
⚫ If  = +1.0, no risk reduction is possible
⚫ If  = -1.0, perfect hedging opportunity exist (zero variance portfolio)
Correlation Effects
⚫ Example 1 : RA,RB = 1 : total risk = sum of risks
⚫ ²RP = [X RA + (1 – X) RB]2
⚫ RP = X RA + (1 – X)RB
⚫ Example 2 : RA,RB = 0
⚫ ²RP = [X² ²RA + (1 – X) ²RB]
⚫ RP < X RA + (1 – X)RB
⚫ Example 3 : RA,RB = -1
⚫ ²RP = [X RA - (1 – X) RB]2
⚫ RP = X RA - (1 – X)RB

Expected Return and Standard Deviation
with Various Correlation Coefficients

The Importance of Diversification : Risk Types
63
Unrewarded Risk Rewarded Risk

c. The Job of a Rational Investor
⚫ Two Operations :
⚫ c’. Maximising Risk/Reward in a weighted portfolio : choose the
best combination of assets in your portfolio
⚫ c’’. Fire the Unsystematic risk : increase the number of assets
in your portfolio

c’. Maximising Risk/Reward in a weighted
portfolio :
choose the best combination of assets in your portfolio
⚫ Example : Portfolio with Boeing and Home Depot (1998)
⚫ ²RP/X = 2x²RA + (2X - 2)²RB + 2RA,RB RARB – 4 RA,RB RARB = 0
⚫ X* = 70,96%
Pondération de Boeing Pondération de Home Depot Rentabilité prévue Ecart-type
100% 0% 8,38% 31,10%
90 10 12,52 25,27
80 20 16,67 21,13
70 30 20,81 19,78
60 40 24,96 21,75
50 50 29,11 26,29
40 60 33,25 32,34
30 70 37,40 39,21
20 80 41,55 46,54
10 90 45,69 54,14
0 100 49,84 61,90
Boeing Weight Home Depot Weight Expected Return SD

Risk-Return Trade-Off
66
Expected Standard
Inputs Return Deviation
Risky Asset 1 14.0% 20.0%
Risky Asset 2 8.0% 15.0%
Correlation 30.0%
Efficient Set--Two Asset Portfolio
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation
Expected
Return
⚫ For the plot, the upper left-hand boundary is the Markowitz efficient frontier
⚫ All the other possible combinations are inefficient. That is, investors would
not hold these portfolios because they could get either more return for a
given level of risk, or less risk for a given level of return

E(R)
R
The Markowitz Efficient frontier
Efficient Frontier
Portefeuille de
variance minimale
⚫ The Markowitz Efficient frontier is the set of portfolios with the maximum
return for a given risk AND the minimum risk given a return

c’’. Increase the number of assets in your portfolio
⚫ Firm-specific risk can be reduced, if not eliminated, by increasing the
number of investments in your portfolio (i.e., by being diversified).
⚫ On economic grounds, diversifying and holding a larger portfolio eliminates
firm-specific risk for two reasons-
⚫ (a) Each investment is a much smaller percentage of the portfolio,
muting the effect (positive or negative) on the overall portfolio.
⚫ (b) Firm-specific actions can be either positive or negative. In a large
portfolio, it is argued, these effects will average out to zero. (For every
firm, where something bad happens, there will be some other firm,
where something good happens.)
68

69
Increase the number of assets in your portfolio

70
At an extreme, one stand alone stock represents its own index, but it has a
very high risk and offers no additional expected return over the asset class
to which it belongs.

71
Transaction
costs
Now we can entry into the CAPM and see the linear
relation between an asset hurdle rate and its risk

C. CAPM : from the Capital Market Line to the
Security Market line
⚫ In the CAPM, all investors have a Global Portfolio with a proportion X of
the Market (risky portfolio with total diversification) and (1-X) of a risk
free asset (T-bills)
ERP = X ERM + (1 – X) rf
As rf = 0, ²RP = X² ²RM ou RP = X RM
The separation property tells us that the portfolio choice problem may be
separated into two independent tasks :
➢Determination of the optimal risky portfolio is purely technical (same for all
clients)
➢Allocation of the complete portfolio to T-bills versus the risky portfolio (P)
depends on personal preference
The Capital Market Line represents the relation between
the Risk of the Global Portolio and its Expected Return

Capital Market Line (CML) : linear relation between
hurdle rate and risk for a GLOBAL PORTFOLIO
⚫ Suppose X = RP / RM
⚫ We get : ERP = rf + (ERM - rf) x RP
RM
a linear relation between expected Return and Total Risk of the
Global Portfolio.
The slope [ERM - rf] / RM gives the Market Premium for RM
Capital Market Line
Market Portfolio
rf
ERP
RP
Markowitz
Frontier

Risk Free
Rate
Market
Portfolio M
Expected
Return
Standard Deviation M
Markowitz
Frontier
Hurdle Rate
on the Market
Market
Premium
Risk Adverse
Investor
CML
Investors’ indifference curves are based on their degree
of risk aversion and investment objectives
Risk Lover
Investor
We are looking for the
Security Market Line
(relation between
the firm systematic Risk
and its Expected Return)

From the Capital Market Line to the Security
Market Line
⚫ Consider the following portfolio : hold a% in asset i and (1-a%) in the
market portfolio. The expected return and standard deviation of such a
portfolio can be written as :
⚫ Arbitrage : Consider the change in the mean and standard deviation with
respect to the percentage change in the portfolio invested in asset i
.
)
1
(
2a
)
1
(
)
(
]
[
)
1
(
]
[
]
[
2
2
2
2
mi
m
i
p
m
i
p
a
a
a
R
R
E
a
R
aE
R
E



 −
+
−
+
=
−
+
=
( )
mi
m
i
p
p
m
i
p
p
p
p
p
a
a
a
R
a
R
R
E
R
E
a
R
E
a
R
a
R
E
R
d
R
dE







)
2
1
(
)
1
(
)
(
1
)
(
]
[
]
[
]
[
)
(
]
[
)
(
]
[
2
2
−
+
−
−
=


−
=






=

Since the market portfolio already contains asset i, therefore, the
percent a in the above equations represent excess demands for a
risky asset.
We know that in equilibrium, Demand = Supply for all asset.
Therefore, a = 0 has to be true in equilibrium.
• the slope of the risk return trade-off evaluated at point M in market
equilibrium is
• but we know that the slope of the opportunity set at point M must also
equal the slope of the capital market line. The slope of the capital
market line is :
• Therefore, setting the slope of the opportunity set equal to the slope of
the capital market line :




m
2
m
im
m
i
p
p
-
)
R
E(
-
)
R
E(
=
a
)/
R
(
a
)/
R
E(




 m
f
m R
-
)
R
E(
(evaluated at a = 0)

( )
( )
rf
-
]
[
2
rf
-
]
[
2
rf
-
]
[
2
]
[
rf
-
]
[
2
]
[
]
[
m
R
E
m
mi
i
R
E
rf
m
m
R
E
mi
m
i
R
E
m
m
R
E
m
m
mi
m
R
E
i
R
E









=

−
=

=
−
−
i
Market premium
i
f
m
f
i ]
R
-
)
R
[E(
+
R
=
)
R
E( CAPM Equation
Where :
E(return) = Risk-free rate of return + Risk premium specific to asset i
E(Ri) = Rf + (Market price of risk)x(quantity of risk of asset i)
E(Ri) = Expected Return on asset i
Rf = Equilibrium Risk-free rate of return
i = Quantity of risk of asset i = COV(Ri, RM)/Var(RM)
[E(RM)-Rf] = Market Price of risk

Interpreting 
⚫ if  = 
⚫ asset is risk free
⚫ if  = 
⚫ asset return = market return
⚫ if   
⚫ asset is riskier than market index
▪   
⚫ asset is less risky than market index
 =
% change in asset return
% change in market return
Amazon 2.23
Anheuser Busch -.107
Microsoft 1.62
Ford 1.31
General Electric 1.10
Wal Mart .80
Sample betas

Pictorial Result of CAPM
E(Ri)
E(RM)
Rf
Security Market
Line
 =
[COV(Ri, RM)/Var(RM)]
= 1.0
slope = [E(RM) - Rf] = Eqm. Price of risk

Security Market Line Equilibrium
A
1 i
A
M
E(Ri)
B
B
Upon the Market Line an asset is
undervalued. Indeed its return is too
high considering its risk. Well informed
investors will buy the asset ; price up
and return down.
Down the Market Line an asset is
overvalued. Indeed its rik is too high
considering its return ; investors will
sell it ; price down and return up.

81
Portfolios in upwards trend

Portefeuille in downwards trend

Telecoms : 18 months of volatility
Cours base 100 de Telecom Monde (INT)
40
60
80
100
120
140
160
180
200
220
mars 99 juin 99 sept 99 déc 99 mars 00 juin 00 sept 00 déc 00 mars 01 juin 01 sept 01 déc 01 mars 02 juin 02
Telecom Global S&P 500 (US)
Source JCFQuant

Estimating the Cost of Equity :
Deutsche Bank 2008 versus 2009
⚫ In early 2008, we estimated a beta of 1.162 for Deutsche Bank, which used in
conjunction with the Euro risk-free rate of 4% (in January 2008) and a risk
premium of 4.50% (the mature market risk premium in early 2008), yielded a cost
of equity of 9.23%.
Cost of EquityJan 2008 = Riskfree RateJan 2008 + Beta* Mature Market Risk Premium
= 4.00% + 1.162 (4.5%) = 9.23%
(We used the same beta for early 2008 and early 2009)
⚫ In early 2009, the Euro riskfree rate had dropped to 3.6% and the equity risk
premium had risen to 6% for mature markets:
Cost of equityjan 2009 = Riskfree RateJan 2009 + Beta (Equity Risk Premium)
= 3.6% + 1.162 (6%) = 10.572%
84

⚫ A. The Riskfree Rate
⚫ B. The risk premium [E(Rm) – Rf]
⚫ C. Estimating Beta
85
1.3. Estimating CAPM items

A. The Riskfree Rate
⚫ Using a long term government rate as the riskfree rate on all of the cash flows in a
long term analysis will yield a close approximation of the true value.
⚫ Note, however, that not all governments can be viewed as default free !
⚫ There can be no uncertainty about reinvestment rates, which implies that it is a
zero coupon security with the same maturity as the cash flow being analyzed.
⚫ But if there is substantial uncertainty about expected cash flows, the present
value effect of using time varying riskfree rates is small enough that it may not
be worth it.
⚫ The riskfree rate should be in the same currency that your cashflows.
⚫ if your cashflows are in U.S. dollars, your riskfree rate has to be in U.S. dollars
as well.
⚫ If your cash flows are in Euros, your riskfree rate should be a Euro riskfree rate.
86

Using time varying riskfree : Premium on Treasury bonds
Premium rises when supply of Treasury securities falls
Premium rises when consumer confidence falls
A “flight-to-liquidity” premium – some investors have strong preference for securities that are
actively traded every minute

B. The risk premium [E(Rm) – Rf]
⚫ Estimates of the equity market risk premium, ie, the difference between the
market return and the risk free interest rate, are currently arrived at using two
possible approaches :
⚫ Either on the basis of historical data relating to rates of returns received by
investors since over very, very long periods. On efficient markets, historical
rates of return should be equal to future rates of return. In this case we refer
to the historical risk premium.
⚫ Or on the basis of forecast data (future free cash flows) and the current
share price, from which we deduct, after a few calculations, the discount rate
used, and thus the risk premium since the discount rate is equal for the whole
of the market at the risk free interest rate plus the risk premium. In this case,
we refer to the anticipated or forward risk premium, because it is based on
investors' current expectations, both anticipated and not anticipated, because
it is the risk that is anticipated not the premium, which is current.
88

The Historical Premium Approach
⚫ This is the default approach used by most (Damodaran)
⚫ This approach does the following :
⚫ defines a time period for the estimation (1926-Present, 1962-Present....)
⚫ calculate average returns on a stock index during the period
⚫ calculate average returns on a riskless security over the period
⚫ calculate the difference between the two and uses it as a premium looking
forward
⚫ The limitations of this approach are :
⚫ it assumes that the risk aversion of investors has not changed in a systematic
way across time.
⚫ it assumes that the riskiness of the “risky” portfolio (stock index) has not
changed in a systematic way across time.
89

Historical Average Premiums for the US
90
Arithmetic average Geometric Average
Stocks - Stocks - Stocks - Stocks -
Historical Period T.Bills T.Bonds T.Bills T.Bonds
1928-2005 7.83% 5.95% 6.47% 4.80%
1964-2005 5.52% 4.29% 4.08% 3.21%
1994-2005 8.80% 7.07% 5.15% 3.76%
What is the right premium ?
⚫ Go back as far as you can. Otherwise, the standard error in the estimate will be
large.
Standard error in estimate = Annualized Standard Deviation in Stock Prices
(Number of years of Historical Data)1/2
⚫ Be consistent in your use of a riskfree rate.
⚫ Use arithmetic premiums for one-year estimates of costs of equity and geometric
premiums for estimates of long term costs of equity.
Historical U.S. equity
risk premium changes
considerably depending
on the interval used to
calculate it !
Arithmetic Average =
R1 + R2 + …….RT
T
Geometric Average =
[(1+R1) (1+ R2) ….. (1+ RT)]1/T – 1
Historical data for markets outside the United States is available for much
shorter time periods. The problem is even greater in emerging markets

One solution : Look at a country’s bond rating
and default spreads as a start
⚫ Ratings agencies such as S&P and Moody’s assign ratings to countries that reflect
their assessment of the default risk of these countries.
⚫ While default risk premiums and equity risk premiums are highly correlated, one
would expect equity spreads to be higher than debt spreads. If we can compute
how much more risky the equity market is, relative to the bond market, we could
use this information.
Country Risk Premium = Country Risk spread x Relative Market Volatility
91
Standard Deviation in Equity Market
Standard Deviation in Long term Bond
Relative Market Volatility =

Country Risk Spread for Emerging Countries
2005 - 2008 (EMBI+ JP Morgan)
Source: CBonds
2005-2007= Huge liquidity + interest rate +
Growth of emerging countries = country risk spreads
2007- 08 =
subprims + credit crunch

Example
⚫ Suppose, Brazil had dollar denominated C-Bonds, trading at an interest rate of
10.01%. The US treasury bond rate that day was 4%, yielding a default spread of
6.01% for Brazil.
⚫ If we can compute how much more risky the equity market is, relative to the bond
market, we could use this information. For example,
⚫ Standard Deviation in Bovespa (Equity) = 36%
⚫ Standard Deviation in Brazil C-Bond = 28.2%
⚫ Default spread on C-Bond = 6.01%
⚫ Country Risk Premium for Brazil = 6.01% (36%/28.2%) = 7.67%
⚫ If you assume that the risk premium in the US is 4.82% (1998-2003 average), the
risk premium for Brazil would be 12.49%.
93

Discussion :
Weaknesses of the historical premium ?
⚫ From a conceptual point of view, only the anticipated risk premium is acceptable for
calculating a discount rate. The price of an asset today = expected discounted cash
flows that it should generate given the rate of return required by the investor today.
⚫ In the historical premium method, calculations have to be based on data over a
very long period in order to reduce the standard deviation of observations and to
arrive at a relevant average. Even over 75 years, the theoretical standard deviation
of observations following a normal rule is 2.5%, which means that a premium of 5%,
for example, has as much chance of being 2.5% as 5% or 7.5%.
94
So UBS estimates that the risk premium for the USA, calculated by Ibbotson since
1926, often cited and used (7.1% on arithmetical average and 5.2% on geometric
average), would change by one point if it were calculated from 1925 or 1927.

Historical inconsistent use of premiums ?
95
From a practical point of view, we see that
those using the historical approach to the risk
premium, often because they believe the
current risk premium to be volatile, which is
true, forget that the risk-free interest rate is
even more volatile, as illustrated by figures for
the French situation since 1980

⚫ It is inconsistent to calculate the risk premium (E (rm) – rf) using a given risk-free
interest rate and in the formula r = rf + ß × (E (rm) – rf), replacing rf with a
different figure from that used to calculate the risk premium (because most of the
time we don’t know what risk-free interest rate was used to calculate the risk
premium).
⚫ When interest rates rise, the risk premium tends to fall. And also, the required
rate of return doesn’t rise as high as the performance of the risk-free interest rate
might lead one to assume, as the risk premium absorbs part of the rate hike.
And vice versa in the event of a fall in interest rates.
96
Be consistent in your use of a riskfree rate
To conclude : contingency of the risk premium
For example, a figure arrived at in July 2006 (on the basis of estimations for the
first half of 2006) is unlikely to be of much relevance in April 2007. Since January
2006, the CAC 40, the Dow Jones and the S&P 500 have risen by between 16
and 19%, although earnings forecasts have not been revised by this amount.
Over the same period, the risk-free interest rate in Europe has risen by 80 points
and in the USA by 45 points, resulting in a fall in the risk premium since this period
of around 70 base points.

97
C. Estimating Beta
a. Bottom-up Beta
b. Top-down Beta

⚫ The standard procedure for estimating betas is to regress stock returns (Rj)
against market returns (Rm) -
Rj = a + b Rm
⚫ where a is the intercept and b is the slope of the regression.
⚫ The slope of the regression (b) corresponds to the beta of the stock, and
measures the riskiness of the stock.
i
Ri
RM
ESTIMATION DU BÊTA
a. Bottom-up Beta

Estimating Performance
Jensen’s Alpha
⚫ The intercept of the regression provides a simple measure of performance
during the period of the regression, relative to the capital asset pricing model.
Rj = Rf + b (Rm - Rf)
= Rf (1-b) + b Rm ........... Capital Asset Pricing Model
Rj = a + b Rm ........... Regression Equation
⚫ If
a > Rf (1-b) ....Stock did better than expected during regression period
a = Rf (1-b) ....Stock did as well as expected during regression period
a < Rf (1-b) ....Stock did worse than expected during regression period
99
The difference between the intercept and Rf (1-b) is Jensen's alpha. If it is
positive, your stock did perform better than expected during the period of
the regression.

Jensen’s Alpha
A 1 
A
M
E(Ri)
A B
A was undervalued
B was overvalued
B

Setting up for the Estimation
⚫ Decide on an estimation period
⚫ Services use periods ranging from 2 to 5 years for the regression
⚫ Longer estimation period provides more data, but firms change.
⚫ Shorter periods can be affected more easily by significant firm-specific
event that occurred during the period
⚫ Decide on a return interval - daily, weekly, monthly
⚫ Shorter intervals yield more observations, but suffer from more noise.
⚫ Noise is created by stocks not trading and biases all betas towards one.
⚫ Estimate returns (including dividends) on stock
⚫ Return = (PriceEnd - PriceBeginning + DividendsPeriod)/ PriceBeginning
⚫ Choose a market index, and estimate returns (inclusive of dividends)
on the index for each interval for the period
101

Example : Disney
⚫ Period used : 5 years
⚫ Return Interval = Monthly
⚫ Market Index: S&P 500 Index.
⚫ For instance, to calculate returns on Disney in December 1999,
⚫ Price for Disney at end of November 1999 = $ 27.88
⚫ Price for Disney at end of December 1999 = $ 29.25
⚫ Dividends during month = $0.21
⚫ Return = ($29.25 - $27.88 + $ 0.21)/$27.88= 5.69%
⚫ To estimate returns on the index in the same month
⚫ Index level (including dividends) at end of November 1999 = 1388.91
⚫ Index level (including dividends) at end of December 1999 = 1469.25
⚫ Return =(1469.25 - 1388.91)/1388.91 = 5.78%
⚫ Using monthly returns from 1999 to 2003, we ran a regression of returns on
Disney stock against the S*P 500. The output is below:
ReturnsDisney = 0.0467% + 1.01 ReturnsS & P 500 (R squared= 29%)
(0.20)
102

Estimating Disney Performance
⚫ Intercept = 0.0467%
⚫ This is an intercept based on monthly returns. Thus, it has to be compared to a
monthly riskfree rate.
⚫ Between 1999 and 2003,
⚫ Monthly Riskfree Rate = 0.313% (based upon average T.Bill rate: 99-03)
⚫ Riskfree Rate (1-Beta) = 0.313% (1-1.01) = -..0032%
⚫ The Comparison is then between
Intercept versus Riskfree Rate (1 - Beta)
0.0467% versus 0.313%(1-1.01)= - 0.0032%
⚫ Jensen’s Alpha = 0.0467% -(-0.0032%) = 0.05%
⚫ Disney did 0.05% better than expected, per month, between 1999 and 2003.
⚫ Annualized, Disney’s annual excess return = (1.0005)12-1= 0.60%
103
Disney has a positive Jensen’s alpha of 0.60% a year between 1999 and 2003. This
can be viewed as a sign that management in the firm did a good job, managing the
firm during the period.
a) True
b) False

Agencies adjustments
⚫ Bloomberg :
Adjusted Bêta = Raw Bêta x 0,67 + 1 x 0,33
⚫ Dividend are no considered
⚫ Period regression is limited to 2 years
US is a mature economy
2/3 of US listed firms have a beta between 0,8 et 1,2

Beta : Exploring Fundamentals
⚫ Industry Effects : The beta value for a firm depends upon the sensitivity of the
demand for its products and services and of its costs to macroeconomic factors
that affect the overall market.
⚫ Cyclical companies have higher betas than non-cyclical firms
⚫ Firms which sell more discretionary products will have higher betas than firms
that sell less discretionary products
⚫ Operating leverage : Other things remaining equal, higher operating leverage
results in greater earnings variability which in turn results in higher betas.
⚫ Fixed Costs Measure = Fixed Costs / Variable Costs
⚫ EBIT Variability Measure = % Change in EBIT / % Change in Revenues
⚫ This measures how quickly the earnings before interest and taxes changes as
revenue changes. The higher this number, the greater the operating leverage.
⚫ Financial Leverage : As firms borrow, they create fixed costs (interest
payments) that make their earnings to equity investors more volatile. This
increased earnings volatility which increases the equity beta
105

Equity Betas and Leverage
⚫ The beta of equity alone can be written as a function of the unlevered beta
and the debt-equity ratio :
L = u (1+ ((1- t)D/E))
Where :
L = Levered or Equity Beta
u = Unlevered Beta
t = Corporate tax rate
D = Market Value of Debt
E = Market Value of Equity
106
The regression beta for Disney is 1.01 during the period of the regression (1999 to
2003) and the average debt equity ratio during this period was 27.5%.
The unlevered beta for Disney can then be estimated (using a tax rate of 37.3%)
= Current Beta / (1 + (1 - tax rate) (Average Debt/Equity))
= 1.01 / (1 + (1 - 0.373)) (0.275) = 0.8615

Boeing : Beta and Leverage
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
0.86 0.92 1 1.1 1.23 1.42 1.7 2.16 3.1 5.89
Debt /Equity Ratio
(%)
Bêta
0,00 0,86
11,11 0,92
25,00 1,00
42,86 1,10
66,67 1,23
100,00 1,42
150,00 1,70
233,33 2,16
400,00 3,10
900,00 5,89
With : rf = 4,5%
[E(RM) – Rf] = 6,38%
Boeing’s Cost of Equity

b. Top-down Beta
⚫ The top-down beta for a firm comes from a regression
⚫ The bottom up beta is a better estimate than the top down beta for
the following reasons :
⚫ The standard error of the beta estimate will be much lower
⚫ The betas can reflect the current (and even expected future) mix
of businesses that the firm is in rather than the historical mix

Find the betas of
other firms in these
businesses
Find the
unlevered
betas of
other firms
in these
businesses
Lever up using
the firm’s
debt/equity ratio
Average
Sectorial
Beta
Take a weighted (by sales or
operating income) average
of these unlevered betas
Find out the businesses that a firm operates in
Several Business
Bottom-up Beta

A single Business : Home Depot
Nom de l’entreprise Bêta Capitalisation
boursière
(millions Euro)
Endettement à
moins d’un an
(Euro)
Endettement à
long terme
(Euro)
D/CP
(%)
Building Materials
Catalina Lighting
Cont’I Materials Corp
Eagle Hardware
Emco Limited
Fastenal Co
Homebase Inc.
Hugues Supply
Lowe’s Cos.
Waxman Industries
Westburne Inc.
Wolohan Lumber
1,05
1
0,55
0,95
0,65
1,25
1,1
1
1,2
1,25
0,65
0,55
0,93
136
16
32
612
187
1 157
227
610
12 554
18
607
76
16 233
1
7
2
6
39
16
1
111
6
9
2
200
113
19
7
146
119
-
116
335
1 046
121
34
20
2 075 14,01
Source : Value Line
Home Depot unlevered Beta = 0,93 / [1 + (1 – 0,35) (0,1401)] = 0,86
Home Depot Market value of Equity = 51 739 millions USD ???
Home Depot Market value of Debt = 1 137 millions USD ???
Home Depot Bottom up Beta = 0,86 [1 + (1 – 0,35) (1 137/ 51 739)] = 0,87
Comparable firms Beta
Market Value
of Equity
Market Value
of Short term
Debt
Market Value
of Long term
Debt
Debt to
Capital

Two areas of Business : Boeing
To estimate Boeing’s beta today, we divided its business into two areas :
Commercial Aircraft ;
Core business of
manufacturing
commercial jet aircraft and
providing related support
services
Information, Space, and
Defense Systems (ISDS) ;
Research, development,
production, and support
of military aircraft,
helicopters, and missile
systems

Two areas of Business : Boeing
Boeing unlevered beta =
value-weighted average of the betas of each of the different business areas = 0.88
Equity Beta for Boeing = 0,88 [1 + (1 – 0,35) (8,2/32,60)] = 1,014
Segment Revenues Estimated
Value
Unlevered
Beta
Segment
Weight
Weighted
Beta
Commercial Aircraft*
ISDS**
Firm
$26,929
18,125
$30,160.48
12,687.50
42,848
0.91
0.80
70.39%
29.61%
100.00%
0.6405
0.2369
0.88
Estimating Unlevered Betas for Boeing’s Business Areas
*We looked at Boeing’s own beta prior to its expansion in the defense business and computed the unlevered
beta using this estimate
**For ISDS, we used 17 firms that derive the bulk of their revenues from defense contracting, and we computed
the average beta and debt/equity ratio for these firms
Value of Debt Market Value of Equity

Beta of firm after an acquisition :
Boeing and Mc Donnell Douglas
⚫ In 1997, Boeing announced that it was acquiring McDonnel Douglas, another
company involved in the aerospace and defense system. At the time of the
acqusition, the two firms had the following market value and betas :
Boeing’s unlevered beta = 0,95/[1 + 0,65 (3 980/32 438)] = 0,88
Mc Donnell Douglas unlevered beta = 0,90/[1 + 0,65 (2 143/12 555)] = 0,81
Unlevered beta for combined firm =
0,88 (36 418/51 116) + 0,81 (14 698/51 116) = 0,86
Company Beta Debt Equity Firm Value
Boeing
Mc Donnell Douglas
0.95
0.90
$3,980
2,143
$32,438
12,555
$36,418
14,698
Weights based on the market value of the two firms

⚫ Boeing’s acquisition of McDonnell Douglas was accomplished by issuing new
stock in Boeing to cover the value of McDonnell Douglas’s equity of $12,555
million. Since no new debt was issued to finance the deal, the debt outstanding
in the firm after the acquisition is just the sum of the debt outstanding at the two
companies before the acquisition :
DebtBoeing = McDonnel Douglas Old Debt + Boeing’s Old Debt =
$3,980 + $2,143 = $6,123 million
EquityBoeing = Boeing’s old Equity + New Equity used for Acquisition
$32,438 + $12,555 = $44,993 million
D/E = $6,123/$44,993 = 13,61 %
New beta = 0,86 [1 + 0,65 (0,1361)] = 0,94
Beta of firm after an acquisition :
Boeing and Mc Donnell Douglas

1.4. Evolution from the CAPM
⚫ CAPM :
⚫ Max return & min risk by diversification
⚫ Diversified-market portfolio return to explain stock return
⚫ Other factors that explain returns?
115
A. The Size Effet : Small Caps versus Large Caps
B. The Value Effect
C. The Fama-French 3 Factor Model
Professors Gene Fama and Ken French (1992, 1993) argue that two additional
factors should be added and appear to be useful in explaining the relationship
between risk and return.
➢Size, as measured by market capitalization : Small company stocks have
higher expected returns than large company stocks.
➢The book value to market value ratio, i.e., B/M : Lower-priced "value" stocks
have higher expected returns than higher-priced "growth" stocks.
Whether these two additional factors are truly sources of systematic risk is still
being debated.

A. The Size Effet :
Small Caps versus Large Caps
⚫ Rolf Banz (1981), University of Chicago
⚫ Analyzed NYSE stocks, 1926-1975.
⚫ Finds that, in the long term, small companies have higher expected returns
than large companies and behave differently.
⚫ Dimensional Fund Advisors is founded in 1981 and launches the first
passive small cap strategy (the US Micro Cap Portfolio).
116

Small Caps versus Large Caps
USA
Europe
Source : Conseil d’Analyse Économique, september 2008
International Size Effect Steven L. Heston, K. Geert Rouwenhorst, and Roberto E.
Wessels find evidence of higher average returns to small companies in twelve international
markets. “The Structure of International Stock Returns and the Integration of Capital Markets,”
Journal of Empirical Finance 2, no. 3 (September 1995): 173-97.

B. The Value Effect
Returns to Value and Growth Stocks
by Country 1975-1995
0%
5%
10%
15%
20%
25%
Average
Annual
Rate
of
Return
Growth
Value
Source : Robert A. Haugen
Prentice Hall, 1999

119
C. The Fama-French 3 Factor Model
⚫ Fama and French (1992) investigate 100 NYSE portfolios for the period
1963-1990
⚫ The portfolios are grouped into 10 size classes and 10 beta classes
⚫ They find that return differential (risk premium) on  is negative (and
non significant)
⚫ whereas return differential on size is large and significant.

Beta vs. Return by size classes
NYSE 1941-1990
0.6 0.8 1 1.2 1.4 1.6 1.8 2
Beta
5%
10%
15%
20%
25%
30%
Return
Big Caps
Small Caps
Prentice Hall, 1999
CAPM seems correct !

0.6 0.8 1 1.2 1.4 1.6 1.8 2
Bêta
5%
10%
15%
20%
25%
30%
Rendements
annualisés
Small Caps
Beta vs. Return : each size classes is divided in betas classes
NYSE 1941-1990
Big Caps
Prentice Hall, 1999
For each size classe, there is an inverse relation between risk and return !
The risk and return relation is in fact a relation size-return

What are the Fama-French findings combining
Value and size effects ?
⚫ 1. “The Cross-Section of Expected Stock Returns”, Eugene F. Fama and
Kenneth R. French, The Journal of Finance, Vol. 47, No. 2 (Jun., 1992),
pp. 427-465
⚫ 2. “Common risk factors in the returns on stocks and bonds”, Eugene F.
Fama and Kenneth R. French, JFE 33, 1993
122
High returns of small and value stocks are compensation of risks not
captured by CAPM

The Fama-French 3 Factor
123
RFPL : an initial estimate of the FPL cost
of common equity during period t
Rf,t : the return on the risk-free asset
β’s are the “betas” for each factor
βi,m is the CAPM “beta”
RPM : difference between returns on a diversified
market portfolio and a risk-free return
SMB (small minus big) : difference between returns
on diversified portfolios of small and large
capitalization stocks
HML (high minus low) : difference between returns
on diversified portfolios of high (distressed firms)
and low B/M (not – distressed firms) stocks
( ) ( ) ( )
HML
SML
RPM
R
R hml
FPL
sml
FPL
m
FPL
f
FPL ,
,
, 

 +
+
+
=
Application : Home Depot’s Fama-French Cost of Equity

⚫ Stock market efficiency
⚫ High returns are compensation for high risks. The knowledge of the
performance is widespread.
⚫ Outperformance is unlikely to continue
⚫ Stock market is not efficient
⚫ An opportunity for sophisticated investors to consistently outperform the
market. No explanation for risk-return compensation.
⚫ Short window of opportunity
The difficulty in identifying the
sources of SMB and HML risks

Pros and Cons
Pros :
⚫ Recently developed addition to the toolkit for estimating the cost of common equity
capital
⚫ Explains a greater proportion of the non-diversifiable volatility of stocks returns
relative to CAPM
Cons :
⚫ Not based on theory, just a “brute force” way to explain more of the volatility in
returns
⚫ Factors are highly volatile as are cost of capital estimates
⚫ Adding any variable to a regression increases R-square
125
Indice Style Dec. 2000 Dec. 2003 Dec. 2007
Larges Caps
Small Caps
Growth
Value
Large Cap Growth
Small Cap Value
Indice général
14,1
7,2
13,7
12,4
14,6
6,0
13,2
4,7
20,6
- 4,3
5,4
- 6,5
24,1
- 1,9
12,8
2,9
12,5
12,2
12,2
2,6
12,5
Returns on 3 years
(annual %)
Source :
www.demarche.com

corporate valuation vietnam - final1.pdf

More Related Content

Similar to corporate valuation vietnam - final1.pdf (20)

Recently uploaded (20)

corporate valuation vietnam - final1.pdf