• Th’ng Beng Hooi, CFA

How to check if your calculations are right in the CFA® Program exam

In this series of posts, we ask your AB Maximus trainers to explain common skills you'll need to ace the CFA® Program exam.

*Note: This topic is not in the official curriculum, but is useful for students to check if their answers are on the right track.

Using the back of envelope calculation method to make sure you’re always approximately right (and not precisely wrong).

The impact of competition on a business is hard to forecast, and involves many assumptions about a business’s different revenue streams. This is on top of selecting the appropriate discount rate to use in a DCF or DDM valuation model.

Here’s a back-of-envelopment calculation method that can give you an idea if your investment decisions are heading in the right direction. We’ll use the case study of Singapore’s newest telcommunications company disrupting the M1 stock price.

Source: TODAY website

On 1 September 2016, three firms submitted a bid to be Singapore’s fourth telco. When the stock market opened the next day, all 3 incumbent telcos were sold down over the course of several months.

The smallest of the incumbents, M1, was the worst hit as its income is primarily dependent on the Singapore mobile business. M1’s price closed at $2.66 on 1 September 2016. At the opening bell the next trading day, its stock price traded at $2.58 and fell to $2.51 by the end of the day.

A back-of-envelope calculation gives a valuation of $2.02. This assumes that before 1 Sep 2016, each incumbent has 1/3 market share, and in the steady future state, four telcos mean 25% market share each.

$2.66 x 25/33 = $2.02

At the end of October 2016, M1 had a mobile market share of 23.7%. M1’s revenue segments include handset sales, fixed services revenue, international call revenue and mobile revenue. Hence the revenue impact of another competitor coming in is far more complex than our previous computation implies.

In September 2016, research analysts downgraded their recommendation to a sell. For example, on 5 September 2016, Maybank Kim Eng issued a target price $2.04.

We now know that Australian firm TPG won the bid as the newest telco. TPG is known to be a discounter , selling its products cheaply. With this information, we can do another back-of-envelope calculation. By discounting our earlier target of $2.02 at a 15% discount, our new target price for M1 shares is revised to $1.72.

Source: Th'ng Beng Hooi

On 19 July 2017, DBS Group Research published a report that had a “fully valued” call with a target price of $1.78 for M1 stock. Other reports stated that M1’s major shareholders (with combined stake of 61%) were not going ahead with a strategic review to dispose of their stake.

As you can see, this back of envelope calculation method does generate values that closely approximate the stock’s real-life value. This approach is helpful in providing a reality check to fundamental valuation.

About the Author

Th’ng Beng Hooi, CFA, lectures on Ethics for AB Maximus & Co. He was previously VP for Dealing and Resource Development at a listed regional stock-broking firm and is the lead co-author of various financial regulatory examination study guides in Singapore and Malaysia.

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