1. Equity Valuation - Applications and Processes

Question 1

Which equation relates the sources of mispricing perceived by an analyst?

Answer 1

There is a framework that divides mispricing perceived by the analyst into two sources: the difference between market price and the intrinsic value (actual mispricing) and the difference between the analyst’s estimate of intrinsic value and actual intrinsic value (valuation error):

IV(Analyst) - price = IV(actual) - price + IV(Analyst) - IV(Actual)

Question 2

Explain the Porter’s five forces?

Answer 2

1) Threat of new entrants in the industry
2) Threat of substitutes
3) Bargaining power of buyers
4) Bargaining power of suppliers
5) Rivalry among existing competitors

The attractiveness (long-term profitability) of any industry is determined by the interaction of these five competitive forces.

Question 3

Which are the three generic strategies a company may employ in order to compete and generate profits?

Answer 3

1) Cost leadership: being the lowest-cost producer of the good
2) Product Differentiation: addition of product features or services that increase the attrectiveness of the firm’s product so that it will command a premium price in the market
3) Focus: employing one of the previous strategies within a particular segment of the industry in order to gain a competitive advantage

Question 4

Explain ‘conglomerate discount’.

Answer 4

Conglomerate discount is based on the idea that investors apply a markdown to the value of a company that operates in multiple unrelated industries, compared to the value a company that has a single industry focus. Conglomerate discount is thus the amount by which market value under-represents sum-of-the-parts value.

Three explanations for conglomerate discounts are:

1) Internal capital inefficiency: the company’s allocation of capital to different divisions may not have been based on sound decisions
2) Endogenous (internal) factors: for example, the company may have pursued unrelated business acquisitions to hide poor operating performance
3) Research measurement errors: some hypothesize that conglomerate discounts do not exist, but rather are a result of incorrect measurement