Question

i. Explain some key macroeconomics approaches and indicators which are useful in valuing equity instruments.
ii. Briefly describe the efficient market hypothesis and its key implications for the practice of equity valuation.
iii. Explain how a company's financial data may be used to value its equity using a Free Cash Flow approach, giving a numerical or real-world example to illustrate your explanation.

maximum of 500 words

Answer 1

1. Valuation of equity instruments depends on growth of the company being valued and the discount rate used (ke : Cost of equity). This ke and growth rate depends on the growth and risk factors of the economy and the industry in which the company is. Thus, many macroeconomic factors affect the value of a company.

Top Down analysis consists of Economy --> Industry --> Company approach.

Factors such as GDP growth rates, Consumer Price Index (CPI) or inflation, currency strength and stability, labour market statistics, interest rates, etc affect value of the company. These factors have an effect on the growth parameters of a company and risk factors as well. So, growth rate expectation changes with these factors. Also, ke changes with these factors.

2. Efficient market hypothesis : Markets can take any form out of three : 1. weak form effiecient 2. semi strong form efficient 3. strong form efficient. Markets are said to be strong form efficient if the stock prices consists of all the information (public as well as private). Markets are said to be semi strong form efficient if the stock prices consists of publicly available information. Markets are said to be weak form efficient if the stock prices include all the past information (related to the stock prices and volume). So, in weak form efficient market, technical analysis sometimes provide abnormal returns. In semi strong form efficient market fundamental analysis sometimes can provide abnormal returns. In strong form effiecient market, no analysis can generate abnormal returns. So, in case markets are strong form then passive investing is followed over active investing.

3. Using FCFF to value a firm

FCFF (Free Cash Flow to Firm)		100	110	121	133	146
Add: Terminal Value (TV)						1,196
Cash flows including TV		100	110	121	133	1,343

Consider above cash flows and TV as per the calculation of WACC and assumption of growth rate

Calculating Discount Rate : Cost of Capital
WACC (Kd*Wd*(1-t)+Ke*We)	13.9%
Kd	12%
weight of debt	8%
tax rate	36.1%
Ke (Rf + beta*(Rm-Rf))	14%
weight of equity	92%
Rf	5.22%
Beta	0.670
Rm	13.82%
Rm-Rf	8.60%

Taking above numbers as assumptions and then calculating the WACC.

For FCFF, WACC is used as a discount rate

For Terminal Value, we use a formula derived from sum of infinite GP : FCFFnextyear/(WACC - terminalgrowth)

PV of all the future FCFF (Enterprise Value)	1,033
Equity Value		1,033
Share Price		2.21

NPV formula is used to compute the present value of all the future cash flows including the terminal value.

This NPV gives us Enterprise Value as Output. This Enterprise value has to be adjusted for net debt to calculate Equity Value. Considering 468 number of shares the share price is 1033/468 i.e. 2.21.