Equity Valuations Flashcards
Goal of Equity Valuations
Goal of Equity valuations is to identify mispriced assets / securities
Three Methods of Valuations
Asset Value is drived from
- Liquidity Value (If the asset is forced to sell)
- Similar Assets
- Future Investement Returns.
Price Vs Value
Price = Observable = Market Price
Intrinsic Value = (Unobservable) = Value of an Asset given a hypothetically complete understanding of the assets investment characteristic
What do valuation assume
- Mispricing Exists: (Price is not equal to value) and (markets are not efficient) -
- Price and Value will converge within a certain Investment Horizon - (What will cause the convergence) (It is important to note that the prices will only converage if there is a catalyst forcing them to converge)
Grossman - Stiglitz Paradox
If markets were informationally efficient, no rational person would incur the cost of valuation.
What are the rewards for market efficiencies
Abrnomal Returns and Excess Risk Adjusted Returns.
Difference between Estimated Value and Market Price is
Also what is the eqation for the difference.
True Mispricing (Alpha) + Error in forcasts / model
Ve-P = (V-P)+(Ve-V)
where V = Correct Value
and Ve = Estimated Value
Alpha = (V-P)
Key Elements of a forcast are
- It should be different from consensus
2. it should be correct.
Going Concern Assumption
The company will continue its activities
Some assets have value only if the company is a going conecern.
If a compay is a retalier which leases its retail shop then what economic assuption must be true for the assets to have any value
Going Concern.
Liquidation Value
Immediate sale of assets (Financial Distress)
This is unlike orderly liqudation of
Defination of Intrinsic Value
Relevant concept of value for valuing public equities
Defination of Fair Market Value
Value at which an asset or liability would change hands between a willing buyer and a seller when they are in no compulsion to buy / sell
We assume that both are informed of all material aspects
Defination of an Investment Value
an asset may be more to a particular buyer (i.e Synergies)
What is the application of valuation
- Selecting Stocks
- Inferring Market Expectations: We assume that price reflects consensus expectations of investors about future performance
- Evaluating Corporate Events. (M&A, Spin-off )
- Rendering Fairness Opinions
- Evaluating Business Strategies
- Communicating with Analysts and Shareholders
- Appraise Private Businesses
- Evaluating Share based Compensation
What is a spin-off
one of the divisions of the company is formed into another company and the shareholder of the principal company also own the new company.
Valuation Process
- Understand the Business
- Forcast Company’s Performance
- Selecting Appropriate Valuation Models
- Converting Forcasts to Valuations
- Applying Valuation Conclusions
What needs to be done to Understand the Company Business
- Industry and Competitive Analysis
- Identify the Economic Drivers of the Business
- Threats and Opportunities
Industry and Competative Analysis
- Industry Attractiveness for sustained profitablity.
- The company’s relative Competative Position within the industry and its competative Strategy. (Cost Leadership / Differenciation and Focused Niche.)Business Model (How it turns its strategy into model)
- How well has the company executed its strategy and what are its prospects for future execution)
What are Portors 5 forces model
- Intra-industry rivalry
- Threat of New Entrants
- Buying Power
- Supplier Power
- Availability of Substitutes
Absolute Valuation Model Vs Relative Valuation Models
Abs Valutation Models = Specifies an Assets intrinsic Value (PV / Discounted CFs or Asset Based Valuations)
Relative Valuations Models = Metods of comparables. Relies on the law of one price. (i.e Similar Assets should sell for same price) (Ex Price Multiples and Enterprise Multiples)
Important to note is that Relative Valuation provides relative measure of over / under valued securties.
Cash Flow for Shareholders Vs Cash Flow for Company Level
CFs can be discounted to arrive at the value of the firm.
At Shareholder Level - Use Dividends
A Company Level - Use Free Cash Flows or Residual Income
Formula for Free Cash Flows
FCF = CFO - Capex - Change in WCs
Asset Based Valuation (part of Absolute Valaution
Uses Market Value of Assets / Resources it controls (such as REITs)
Law of One Price
Similar Assets should sell for same price
Sum of the Parts Valuation
Also Known as Breakup or Private Market Value
It is the estimated value of the company by the sum of the estimated values of the various businesses (considered as independent going concerns)
We do not want to apply single valuation for businesses that have diverse segments in different industries.
Used when the segments have few synergies between them. (not necessaries zero). It is also useful for valuation spin-offs + pure play premium
To do the pure play. we need a detailed breakup of Revenue and CFs of each business segment.
Conglomorate Discount
The market typically applies a discount to the stock of a compay operting in multiples, unrelated businesses.
The reason for a discount rather than a premium (due to Synergies are)
- inefficiencies in capital allocation (Capital is not allocated across business segments to increase shareholders value.
- Path to congolomorate statsus (Poorly performing companies tend to expand by diversifying the earnings through acquisitions in unrelated businesses. base.)
- Measurement Error.
What are the broad criterias for Equity Valautions
- Consistent with the characteristics of the company being valued.
- Appropriate given the availability and quality of data
- Consistent with the purpose of valuation, including the analysts perspectives.
Use of multiple models and valuation approaches
Converting, forcasts to valuations
Sensitivity analysis
And Situational Adjustments. Such as 1) Control Premium, 2) Lack of Marketability discount 3) illiquidity Discount.
Holding Period Return
Rh = (Dh+Ph)/P0 - 1
Also
Rh = (Dh/P0) + (Ph-P0)/P0
Rh = Divdend Yield + Price Appreciation Return
Realized Holding Priod Return vs Expected Holding Period Return
Realized HPR is based on historical return and the required rate of return is already known. we compare the Realized HPR with the required rate of return (bench mark rate) and estimate whether an investment is acceptable or not.
Whereas Expected HPR is based on future and required rate of return is estimated. We compare the Expected HPR with the expected rate of return (expected bench mark rate) to estimate whether an investment is acceptable.
Define Required Rate of Return
Minimum Level of expected return for a specified time period given an asset’s risk.
If the exptected rate of return is higher than the required rate of return then the purchasing asset is
Under valued
If the exptected rate of return is lower than the required rate of return then the purchasing asset is
Over Valued.
Formula for Required rate of return
R = rf + B(Rm-rf)
CAPM Formula
What is Excess Alpha
What is the formula for Excess Alpha
Excess Alpha = Excess Return / Abnormal Return
E(Alpha) = Rm -rf
Analyst says “ Asset A is mispriced as per my calculation”. What is wrong with this
Asset A is believed to be mispriced.
Problem: P0 = 127.97, required rate of return drived from CAPM mode is 6.3%. Based on our calculation we he arrived at a valuation of V0 = 176.30
What is the expected rate of return, if the convergence period is
a) 1 year
b) 9 months
c) 2 years
a) 1 year
rt = 6.3%
E(R) = rt+ (v0-p0)/p0
= 6.3 + (176.30-127.97)/127.97
= 6.3 +37.77 = 44.07%
b) for 9 months
E(R) = [(1.063)^(0.75)-1] + (v0-p0)/ p0
= 42.26%
c) for 2 years
E(R) = [(1.063)^2-1] + (v0-p0)/p0
= 50.77%
Annulized rate = (1.5077)^(0.5)-1 = 22.79%
Problem: P0 = 33.31, Div= 0.96, r = 7% and one year price target is = USD 37.50 what is Expected Alpha
Also what is the expected return
formual = E(R) = rt + (V0-p0)/p0
But we need to find P1 to compare with Vo = 37.50
p1 = (1.07)*(33.31) - 0.96
p1 = 34.68
Hence Alpha = (37.50-34.60)/34.60 = 8.1315%
Expected Return = (7%) + 8.1315% = 15.1315%
