CFA Institute Investment Foundations Program: Chapter 10 – Equity Securities (Part IV)

In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here).  It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing.  Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.

There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations.  This series of articles will highlight the core knowledge of each chapter.

Chapter 10 provides an overview of equity securities. The learning outcome of chapter 10 is as follows:

·       Describe features of equity securities;

·       Describe types of equity securities;

·       Compare risk and return of equity and debt securities;

·       Describe approaches to valuing common shares;

·       Describe company actions that affect the company’s shares outstanding.

Valuing common shares is a complex process because of their infinite life and the difficulty of estimating future company performance. There are three basic approaches to valuing common shares:

·       Discounted cash flow valuation

·       Relative valuation

·       Asset-based valuation

Analysts frequently use more than one approach to estimate the value of a common share. Once an estimate of value has been determined, it can be compared with the current price of the share, assuming that the share is publicly traded, to determine whether the share is overvalued, undervalued, or fairly valued.

The discounted cash flow (DCF) valuation approach takes into account the time value of money. This approach estimates the value of a security as the present value of all future cash flows that the investor expects to receive from the security. This valuation approach applied to common shares relies on an analysis of the characteristics of the company issuing the shares, such as the company’s ability to generate earnings, the expected growth rate of earnings, and the level of risk associated with the company’s business environment.

Common shareholders expect to receive two types of cash flows from investing in equity securities: dividends and the proceeds from selling their shares. The following example illustrates the application of the DCF approach, using estimates of dividends and selling price, for a common share of Volkswagen.

  

The relative valuation approach estimates the value of a common share as the multiple of some measure, such as earnings per share (EPS) or revenue per share. The multiple is determined based on price and the relevant measure for publicly traded, comparable equity securities. The key assumption of the relative valuation approach is that common shares of companies with similar risk and return characteristics should have similar values. Relative valuation relies on the use of price multiples of comparable, publicly traded companies or an industry average.

One multiple commonly used in relative valuation is the price-to-earnings ratio (P/E), which is the ratio of a company’s stock price to its EPS. For instance, a publicly traded company that generates annual earnings per share of $1.00 and is trading at $12 per share has a P/E (or price-to-earnings multiple) of 12. The following example illustrates two applications of the relative valuation approach.

The asset-based valuation approach estimates the value of common stock by calculating the difference between the value of a company’s total assets and its outstanding liabilities. In other words, the asset-based valuation approach estimates the value of common equity by calculating a company’s net asset value. The asset-based valuation approach implicitly assumes that the company is liquidated, sells all its assets, and then pays off all its liabilities. The residual value after paying off all liabilities is the value to the shareholders.

The DCF valuation approach relies solely on estimates of a company’s future cash flows and implicitly assumes that the company will continue to operate forever. In contrast, the asset-based valuation approach implicitly assumes that the company will stop operating and essentially provides a liquidation value.

The relative valuation approach does not estimate future cash flows but instead uses price multiples of other comparable, publicly traded companies to arrive at an estimate of equity value. These price multiples rely on performance measures, such as EPS or revenue per share, to estimate value. The relative valuation approach implicitly assumes that common shares of companies with similar risk and return characteristics should have similar price multiples.

Companies undertake major changes as they grow, evolve, mature, or merge with another company. Some of these changes result in changes to the number of common shares outstanding—the number of common shares currently held by shareholders. Various corporate actions can affect equity outstanding:

·       Selling shares to the public for the first time (when a private company becomes a public company), referred to as an initial public offering (IPO)

·       Selling shares to the public in an offering subsequent to the initial public offering, referred to as a seasoned equity offering or secondary equity offering

·       Buying back existing shares from shareholders, referred to as a share repurchase or share buyback

·       Issuing a stock dividend or conducting a stock split

·       Issuing new stock after the exercise of warrants

·       Issuing new stock to finance an acquisition

·       Creating a new company from a subsidiary in a process referred to as a spinoff

Sample question:

Which of the following corporate actions would decrease a company’s number of outstanding shares?

A Share repurchase

B Exercise of warrants

C Seasoned equity offering

 

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Source: https://www.cfainstitute.org/en/programs/investment-foundations