A: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued or undervalued by the market

Question 1

An asset is fairly valued if the market price is equal to its estimated intrinsic value, undervalued if the market price is less than its estimated value, and overvalued if the market price is greater than the estimated value.

Answer 1

Intrinsic value or fundamental value is defined as the rational value
investors would place on the asset if they had full knowledge of the
asset’s characteristics

Intrinsic Valuation: Two steps: First, use valuation models to estimate intrinsic values.
Next, compare to market prices to determine whether overvalued,
undervalued, or fairly valued.

Question 2

For security valuation to be profitable, the security must be mispriced now and price must converge to intrinsic value over the investment horizon.

Answer 2

Whether to invest is based on differences in market and intrinsic
values
– Larger the % difference between market price and estimated
value, the more likely to transact
– Degree of confidence in the valuation model used
– Degree of confidence in the assumptions (inputs)
– Depth of coverage can help assess reasonableness of market price
– Investor must expect price will move to intrinsic over their
investment horizon

Question 3

Securities that are followed by many investors are more likely to be fairly valued than securities that are neglected by analysts.

Answer 3

Is intrinsic (absolute) value higher or lower than current market price?
– Intrinsic value > market price = buy
– Intrinsic value < market price = sell
• Is intrinsic (absolute) P/E higher or lower than current market P/E?
– Intrinsic P/E > market P/E = buy
– Intrinsic P/E < market P/E = sell
– Value = Earnings * P/E (one means of valuation)

If an analyst estimates the intrinsic value for a security that is different from its market value, the analyst should most likely take an investment position based on this difference if: the model used is not highly sensitive to its input values.

In general, an analyst can be more confident about an estimate of intrinsic value if the model used is not highly sensitive to changes in its inputs. If a large number of analysts follow a security, its market value is more likely to be a reliable estimate of its intrinsic value. A security that does not trade frequently or in a liquid market may remain mispriced for an extended time, and thus may not result in a profit within the investment horizon even if the analyst’s estimate of intrinsic value is correct

Question 4

Introduction to Equity Value Analysis

Answer 4

Intrinsic value is defined as the rational value investors would
place on the asset if they had full knowledge of the asset’s
characteristics
Intrinsic value analysis differs from and contrasts with
“technical analysis.” Technical analysis seeks to predict
price movements and base investment decisions on the
direction of predicted change in prices.
The fundamentals to be considered depend on the approach
being used in the valuation.

In a top down approach, an analyst examines the economic
environment, identifies sectors that are expected to
prosper in that environment, and analyzes securities of
companies from previously identified attractive sectors.
In a bottom up approach, an analyst typically follows an
industry or industries and forecast fundamental for the
company in order to determine valuation.
An analyst who estimates the intrinsic value of an equity
security is implicitly questioning the accuracy of the
market price as a accurate estimate of value.