Les fiches techniques

Methodological note n°0 : glossary

The terms used on our website and in our methodological notes are defined below.
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Unlevered : describes any financial indicator calculated after neutralizing the effect of financial debt. For example, unlevered net income is equivalent to net operating profit after tax (NOPAT). Or, the unlevered enterprise value is equivalent to shareholders' equity value in the absence of financial debt and non-operational assets..
 
APV approach : the adjusted present value approach corrects cash flow forecasts for several kinds of risk, particularly the one resulting from debt, rather than adjusting the discount rate. For example, in order to account for financial debt, unlevered cash flow is increased to reflect the positive effect of tax-shield savings and decreased by the negative effects of: i) the systematic cost of leverage (SCL); and ii) the expected cost of default(LCD). See methodological note 5.
 
Beta: in the sense of the capital asset pricing model (CAPM) the beta, β, or systematic risk coefficient, is the variable that determines the expected return for a risky financial asset. Each sector beta provided on our website is calculated on the basis of the sector portfolio's monthly returns over the past three years. These returns correspond to the average returns of the companies in the portfolio, weighted by the prevailing market capitalization before calculating each price change.
See note 6 (to be published).
 
Cost of debt: kD refers to the rate a company pays, at a given time, to borrow from credit institutions or to issue debt securities on the markets. It can be broken down into a risk-free rate and a spread that reflect the financial risk of the company.
Fairness Finance's estimate of the cost of debt consists of regressing yields to maturity observed at a given date for a large number of listed fixed-rate in fine bonds, with financial risk indicators (in particular the credit rating of the bond), the size of the company and the residual maturity of the instrument (see methological note 7).
When calculating a weighted average cost of capital, the cost of debt must be adjusted of interest deductibility by calculating a cost of debt after tax (see WACC).
 
Cost of equity : ke refers to the rate of return required, at a given time, by shareholders to invest in a company. In accordance with the CAPM, it must ensure the remuneration of the systematic risk of the investment through a risk premium adjusted by a Beta. The sum of this adjusted premium and the risk-free rate represents the expected return on investment, E(ke). This rate is also an opportunity cost for the investor, and therefore a discount rate.
However, such a rate is only suitable if the cash flow forecasts are mathematical expectations. Generally, these are conditional expectations in case of survival, and are subject to an optimism bias. To correct these biases, the cash flows can be reduced to take into account the probabilistic losses in case of default and the optimism bias. The alternative, more commonly used, is to correct the forecasting bias via the discount rate, by increasing the expectation of return on equity, E(ke), of a premium for optimism bias ΠO and a default risk premium Πd. The cost of equity thus calculated is qualified as conditional, to mark the fact that it is different (generally superior) to the expected return, and that it is intended only to establish a discount rate adapted to the forecasts of a business plan.
 
Unlevered beta : deducted from the beta of a listed share (which is affected by the company's leverage) by applying the Robert Hamada formula (1972) that links the company's leverage and the systematic risk of its stock. For companies with surplus cash, this cash is considered a risk-free asset, distributable after tax.
See notes n° 5 and n° 6 (to be published).
 
Financial leverage : quotient of the value of the net financial debt, recognized in the balance sheet, relative to the market value of the company's shareholders equity. It can also be measured by comparing the net financial debt to the enterprise value (EV), which is estimated by adding the net financial debt and the market value of equity (see WACC below). .
If the debt arises from fully consolidated accounts, the value of minority interests should be taken into account when estimating the total value of equity.
 
Forecast biases : according to the CAPM, forecast cash flows contributing to expected stock returns are mathematical expectations. However, the cash flow forecasts available to us are almost exclusively conditional expectations in the event of companies' survival. Therefore, they do not take into account any/sufficient probabilities of default, which are negligible only for a tiny minority (benefiting from the equivalent of an AAA rating). On the other hand, forecasts in the case of company's survival are themselves tainted by an optimistic bias. This explains why the the expected market return is less than the implied cost of capital that we calculate, to correct these forecast biases
 
CAPM/MEDAF : the capital asset pricing model defines the return expectancy of a risky financial security, E(Ri), by a linear relationship in which its beta, βi, is the explanatory variable, the CAPM risk premium, ΠR, the slope and the risk free rate, rf, is the intercept :
It should be noted that since the market beta equals 1, the expected market return is equal to the sum of the CAPM risk premium and the risk free rate. The CAPM requires that the flows that help make up the expected returns are mathematical expectations. If this is not the case, then the cost of capital required to discount cash flows forecasts is different from the expected return.
 
Firm cash flow : FCF (unlevered cash flow or cash flow from operations). Unlike equity cash flow, this is calculated without taking into account after-tax financial expenses or the change in net debt. FCF is discounted at the WACC rate in a DCF model. It is also used in the APV approach.
See notes n° 1 and n° 5.
Equity cash flow :ECF is free cash flow to equity. It corresponds to the cash earnings adjusted for: i) changes in working capital requirements; ii) investments net of proceeds from the disposal of fixed assets; and iii) the share of these marginal assets needs that can be financed by debt (taking into account a target leverage, for instance). ECF cannot be permanently higher than the net result of a company, otherwise its equity would become negative. In addition, a reinvestment in equity may be taken into account when there is a prudential constraint, which is thus included in our cash flow forecast calculation model for the banking and insurance sectors.
See note n° 2.
 
Implied cost of capital : kL is the IRR which equates the discounted present value of the equity cash flow forecasts and the market capitalization of each of the companies included in our samples. The average of these IRRs, weighted by capitalizations, is the market implied cost of capital. This is the average rate required to discount future cash flows. As these flows are tainted by forecast biases, the implied cost of capital is higher than the market expected return.
See notes n° 2 and n° 3.
 
Market expected return : E(RM) is the expected return on the equity market as it results from our model of implied cost of capital based on sell side analysts' cash flow forecasts. To the extent that cash flow forecasts are not strict mathematical expectations, the market return expectation is different from the market implied cost of capital. In the Fairness Finance model, the market return expectancy is equal to the sum of the CAPM risk premium and the risk free rateE(RM) = ΠR + rf ; or the implied cost of capital less i) the default risk premium and ii) the risk premium for optimism bias;
 
 
See notes n° 2 et n° 3.
 
Risk premium for optimism bias : ΠO is an additional risk premium that corrects a systematic forecast bias on the part of financial analysts (internal and external). Indeed, the forecasts that we use, which generally assume a company's survival (not adjusted for default risk) are furthermore overly optimistic. ΠO corrects this average optimism bias in analysts' cash flow forecasts. Any reasonably optimistic forecast should therefore be discounted at a rate including this premium that corrects the average bias observed for the overall market.
See note n° 3.
 
Default risk premium : Πd is an additional risk premium that corrects the systematic forecast bias financial analysts tend to have (internal and external). If a company's cash flow forecasts are not adjusted for default risk, then Πd should be included in the calculation of the discount rate. Πd is the weighted average premium of the companies included in our sample, which corresponds to a BBB rating.
See note n° 3.
 
Market Equity risk premium : ΠE is the total gap between the implied cost of capital (kL), which we calculate using the market's IRR, and the risk free rate (rf). In the Fairness Finance model, the market risk premium equals the sum of the CAPM risk premium stricto sensu, and the forecast biases premia including the default risk premium (Πd), and the risk premium for optimism bias (ΠO).
 
 
See note n° 3.
 
CAPM risk premium : ΠR is the gap between the market expected return and the risk free rate : E(RM) – rf . In the Fairness Finance model, which corrects for forecast biases, the market return expectation is lower than the implied cost of capital.
See note n° 3.
 
Size risk premium : ΠL is the average positive return gap between a company smaller than the market index average and the market's implied cost of capital, kL. According to the Fairness Finance methodology, this is a residual difference which is not explained by systematic risk (beta), or debt leverage.
See notes n° 3 and n° 4.
 
Risk free rate : rf  is the yield on fixed-rate government bonds with a 10-year maturity. For our european sample, we use a basket of eurozone bonds rated at least AA for which the returns are weighted by the contribution of these states to our basket's GDP. For the North american sample, these are the treasury bonds issued by the federal government of the United States. For the record, forecasts outside the eurozone (notably in sterling) are converted into euros. Likewise, data in Canadian dollars are converted to US dollars.
 
Tax rate : Target corporate tax rate applicable to calculate the tax savings related to the deductibility of financial expenses, adjusted for any legal limits.
This rate is the one used in the calculation of the WACC (see WACC). It may be significantly different from the standard tax rate applicable to other expenses and income.
 
WACC : the weighted average cost of capital is equal to the average of the cost of equity and the cost of financial debt after tax, each of which is weighted by its share in enterprise value:
 
 
Where WACCi denotes the weighted average cost of capital of the company "i", EV the enterprise value of the latter, E the market value of its equity (as calculated in the DCF model), D the amount of net debt, ke,i the cost of equity and kD,i that of debt. As a reminder :
See note n° 1.
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