Equity Valuations

Question 1

Goal of Equity Valuations

Answer 1

Goal of Equity valuations is to identify mispriced assets / securities

Question 2

Three Methods of Valuations

Answer 2

Asset Value is drived from

1. Liquidity Value (If the asset is forced to sell)
2. Similar Assets
3. Future Investement Returns.

Question 3

Price Vs Value

Answer 3

Price = Observable = Market Price
Intrinsic Value = (Unobservable) = Value of an Asset given a hypothetically complete understanding of the assets investment characteristic

Question 4

What do valuation assume

Answer 4

1. Mispricing Exists: (Price is not equal to value) and (markets are not efficient) -
2. 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)

Question 5

Grossman - Stiglitz Paradox

Answer 5

If markets were informationally efficient, no rational person would incur the cost of valuation.

Question 6

What are the rewards for market efficiencies

Answer 6

Abrnomal Returns and Excess Risk Adjusted Returns.

Question 7

Difference between Estimated Value and Market Price is

Also what is the eqation for the difference.

Answer 7

True Mispricing (Alpha) + Error in forcasts / model

Ve-P = (V-P)+(Ve-V)
where V = Correct Value
and Ve = Estimated Value
Alpha = (V-P)

Question 8

Key Elements of a forcast are

Answer 8

1. It should be different from consensus

2. it should be correct.

Question 9

Going Concern Assumption

Answer 9

The company will continue its activities

Some assets have value only if the company is a going conecern.

Question 10

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

Answer 10

Going Concern.

Question 11

Liquidation Value

Answer 11

Immediate sale of assets (Financial Distress)

This is unlike orderly liqudation of

Question 12

Defination of Intrinsic Value

Answer 12

Relevant concept of value for valuing public equities

Question 13

Defination of Fair Market Value

Answer 13

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

Question 14

Defination of an Investment Value

Answer 14

an asset may be more to a particular buyer (i.e Synergies)

Question 15

What is the application of valuation

Answer 15

1. Selecting Stocks
2. Inferring Market Expectations: We assume that price reflects consensus expectations of investors about future performance
3. Evaluating Corporate Events. (M&A, Spin-off )
4. Rendering Fairness Opinions
5. Evaluating Business Strategies
6. Communicating with Analysts and Shareholders
7. Appraise Private Businesses
8. Evaluating Share based Compensation

Question 16

What is a spin-off

Answer 16

one of the divisions of the company is formed into another company and the shareholder of the principal company also own the new company.

Question 17

Valuation Process

Answer 17

1. Understand the Business
2. Forcast Company’s Performance
3. Selecting Appropriate Valuation Models
4. Converting Forcasts to Valuations
5. Applying Valuation Conclusions

Question 18

What needs to be done to Understand the Company Business

Answer 18

1. Industry and Competitive Analysis
2. Identify the Economic Drivers of the Business
3. Threats and Opportunities

Question 19

Industry and Competative Analysis

Answer 19

1. Industry Attractiveness for sustained profitablity.
2. 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)
3. How well has the company executed its strategy and what are its prospects for future execution)

Question 20

What are Portors 5 forces model

Answer 20

1. Intra-industry rivalry
2. Threat of New Entrants
3. Buying Power
4. Supplier Power
5. Availability of Substitutes

Question 21

Absolute Valuation Model Vs Relative Valuation Models

Answer 21

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.

Question 22

Cash Flow for Shareholders Vs Cash Flow for Company Level

Answer 22

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

Question 23

Formula for Free Cash Flows

Answer 23

FCF = CFO - Capex - Change in WCs

Question 24

Asset Based Valuation (part of Absolute Valaution

Answer 24

Uses Market Value of Assets / Resources it controls (such as REITs)

Question 25

Law of One Price

Answer 25

Similar Assets should sell for same price

Question 26

Sum of the Parts Valuation

Answer 26

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.

Question 27

Conglomorate Discount

Answer 27

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) 1. inefficiencies in capital allocation (Capital is not allocated across business segments to increase shareholders value. 2. Path to congolomorate statsus (Poorly performing companies tend to expand by diversifying the earnings through acquisitions in unrelated businesses. base.) 4. Measurement Error.

Question 28

What are the broad criterias for Equity Valautions

Answer 28

1. Consistent with the characteristics of the company being valued. 2. Appropriate given the availability and quality of data 3. 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.

Question 29

Holding Period Return

Answer 29

Rh = (Dh+Ph)/P0 - 1 Also Rh = (Dh/P0) + (Ph-P0)/P0 Rh = Divdend Yield + Price Appreciation Return

Question 30

Realized Holding Priod Return vs Expected Holding Period Return

Answer 30

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.

Question 31

Define Required Rate of Return

Answer 31

Minimum Level of expected return for a specified time period given an asset's risk.

Question 32

If the exptected rate of return is higher than the required rate of return then the purchasing asset is

Answer 32

Under valued

Question 33

If the exptected rate of return is lower than the required rate of return then the purchasing asset is

Answer 33

Over Valued.

Question 34

Formula for Required rate of return

Answer 34

R = rf + B(Rm-rf) | CAPM Formula

Question 35

What is Excess Alpha | What is the formula for Excess Alpha

Answer 35

Excess Alpha = Excess Return / Abnormal Return | E(Alpha) = Rm -rf

Question 36

Analyst says " Asset A is mispriced as per my calculation". What is wrong with this

Answer 36

Asset A is believed to be mispriced.

Question 37

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

Answer 37

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%

Question 38

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

Answer 38

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%