sabaruch

Morgan Bondillo, CFA, is attempting to calculate the value of Smith Sprockets. She is using a supply-side model to estimate the equity risk premium and a build-up model to estimate returns.
Based on the strategies Bondillo is using, Smith Sprockets is least likely to:

A) be closely held.

B) need its beta adjusted for drift.

C) be located in a developed market.

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Supply-side models work best in developed countries, where public equities represent a significant share of the economy, suggesting that there is a relationship between macroeconomic variables and asset prices. The use of a supply-side model suggests Smith Sprockets is in a developed market. Build-up models are generally used for closely held companies for which betas are not easy to obtain. Bondillo’s use of a build-up model suggests Smith Sprockets is probably closely held. Betas of public companies must be adjusted for drift. However, since the use of the build-up method suggests the company is closely held and has no beta available, beta drift is probably not relevant for Smith Sprockets.

sabaruch

Senior analyst James Matin is instructing a room full of new hires in the finer points of equity valuation. He makes two statements:

Statement 1:	“When the return you expect for a stock doesn’t match the required return, make sure you calculate a convergence yield and build that into your valuation model.”
Statement 2:	“When you estimate the equity return of a thinly traded company, the Pastor-Stambaugh model is a better option than the Fama-French model.”

Do the statements represent good advice?

Statement 1

Statement 2

A) No Yes

B) Yes No

C) Yes Yes

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Statement 1 is not good advice because in some cases market inefficiencies will prevent the price from converging with intrinsic value. As such, Matin’s advice is not sound. Statement 2 is good advice, as the Pastor-Stambaugh model adds a liquidity factor to the traditional Fama-French model. Such a liquidity factor would be useful in the analysis of a thinly traded stock.

sabaruch

Types of estimates of the equity risk premium are least likely to include:

A) macroeconomic model estimates.

B) ex-ante estimates.

C) extemporized estimates.

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There are four types of estimates of the equity risk premium: historical estimates, forward-looking (ex-ante) estimates, macroeconomic model estimates, and survey estimates.

sabaruch

There is a multistep process used to estimate the beta of nonpublic companies. What extra step must be taken to use the process on thinly traded public companies?

A) No extra step must be taken.

B) Beta must be reduced using a liquidity factor.

C) Beta must be adjusted to reflect debt and equity levels.

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The same procedure is used for both nonpublic and thinly traded public companies. Beta is adjusted to reflect debt and equity levels for both types of companies. The procedure for estimating beta for private or thinly traded public companies does not involve a liquidity factor.

sabaruch

In the process of estimating beta for a private company, unlevering the beta calculated for the publicly traded comparable company accomplishes what goal?

A) Establishing a baseline level of leverage.

B) Isolating market risk.

C) Improving the accuracy of the estimate in the event that the private company’s debt is of low quality.

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Market risk, also known as systematic risk, is the risk common to all assets within a certain class. Deleveraging the beta strips out the company-specific risk related to the target company’s leverage, thereby isolating market risk. Beta calculations do not require a baseline level of leverage. The equation for calculating beta for private companies assumes the company in question has high-grade debt. The deleveraging process will not help if the assumption is incorrect

sabaruch

Adjusted beta for public companies compensates for:

A) leverage.

B) changes in the market’s growth rate.

C) drift.

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An adjusted beta is a weighted average of the estimated beta and either 1.0 (the average for all stocks) or a peer mean (the beta of similar firms). The objective of an adjusted beta measure is to compensate for beta drift, or the tendency of beta to revert to 1.0 (or the industry average).

sabaruch

Equity analyst Mason Kramer wants to calculate the return on equity for a number of stocks. Kramer values predictive power over all other factors and is in no hurry to finish the work. Which model is Kramer’s best option?

A) Build-up.

B) Multifactor.

C) Capital asset pricing.

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Multifactor models are more robust than the other alternatives. They are also more complex, but given Kramer’s goals, a multifactor model makes the most sense.

sabaruch

Juliann Kellmann, CFA, wants to quickly and simply calculate the expected return of equity in a company with few shares outstanding. She should use:

A) a build-up model.

B) a multifactor model.

C) the capital asset pricing model.

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Build-up models are very simple and apply to closely held companies. CAPM does not work well with such companies. A carefully assembled multifactor model can take liquidity issues into account, but the procedure is far more complex than that of a build-up model.

sabaruch

If an analyst uses a build-up model to estimate a stock’s return rather than using a multifactor model or the capital asset pricing model, the analyst is probably least concerned about:

A) simplicity.

B) timeliness.

C) accuracy.

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The build-up model typically uses historical values as estimates. Historical data may no longer be relevant, so a user of the build-up model is probably not concerned with timeliness.

sabaruch

The country risk rating model:

A) determines a risk premium for any foreign market.

B) depends on forecasts of exchange rates.

C) determines a risk premium for an emerging market.

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The country risk rating model begins with a model from a developed country, then modifies that model with inputs from an emerging market to derive a risk premium for the emerging market. Forecasts of exchange rates may well be part of the model, but they are not a requirement