Fundamental Analysis Flashcards
Explain why the following statements are myths
- A valuation is an objective search for “true” value
- A good valuation provides a precise estimate of
value - More quantitative models are better
- All valuations are subjective
- There are no precise valuations Payoff to valuation is greatest when most uncertain
- One understanding of a valuation model is inversely proportional to the number of inputs, simple valuation models often perform better
Describe the Framework for analysis of company value
P = Sum of expected cash flows discounted back by expected cost of equity + growth options
All valuation boils down to the above equation
“Value” investors focus on identifying companies whose expected ash flows are under-estimated by the market
“Market timers” focus on identifying changes in cost of equity and changes in investors appetite for risk
Valuation of growth options discussed in week 10
What does the discounted rate E[R} depend on?
Discount rate, E[R] depends on the money supply and other uses for money. In a strong economy, there are more
competing attractive investments so cost of money is higher
What has the most impact on expected cash flows E[CF} and what do value investors focus on?
Firm-specific factors for example quality of management,
effectiveness of strategy have most impact on expected cash flows, E[CF]. Barriers to entry are also important.
“Value investors” focus on expected cash flows and the
extent the firm can erect barriers to entry by differentiating
its product and making it hard for others to compete.
What are the three principal steps in DCF valuation
- Estimate free cash flows from investment, cash available to distribute to providers of capital
Usually, FCF calculated on an after-tax basis.
Two categories of FCFs: (a) “predictable” flows over
identifiable periods and (b) “terminal” flows - cash flows
expected beyond the last period we can forecast.
Terminal flows usually have least “information” to support
them but can comprise major part of value of investment.
2.Estimate required rate of return and discount FCFs required at each period by this rate
RoR = Risk free rate plus premium for risk. Key question:
how much of a risk premium is required?
In principle, capital asset pricing model (CAPM) is used to
estimate RoR. In practice, many sensible people use a
nice round number (e.g., 10% or 15%) as the discount
rate. It’s absurd to use an estimate such as 11.3% as you can’t have that level of accuracy.
- Sum present value of the FCFs
If the investment is a company, subtract value of debt to
get equity holders’ portion of enterprise value. Divide the
equity holders’ portion of enterprise value by number of
shares on issue to get value per share
Do a sensitivity analysis to see how estimated value
changes in response to changes in (a) discount rate, (b)
growth rate, (c) other variables such as capital investment
Make adjustments to reflect particular circumstances
apply a further discount if valuing for minority
shareholders; add premium for growth opportunities
How useful is DCF method of valuation
Usefulness of DCF is a function of accuracy of estimates
of cash flows
Cash flows are a function of the company’s economic
environment, which is very difficult to predict but that is
where we must start
What is the formula for FCF
Sales volume x Profit per sales = Free cash flows
What are factors that affect sales volume and Profit margin
Firms Competitiveness: Cost of production, Product Differentiation
Industry attractiveness: Barriers to entry, Leverage capacity
Macroeconomic settings
How detailed should the model be?
There is an inverse relationship between complexity
of the business and complexity of the model
More complex businesses requires simpler models
Businesses with steady, predictable cash-flows can be modeled in more detail
Imprecision in estimates of key variables such as cost of capital make detailed models useless
What is the 3 ways that value is created
- Providing a service/product at price above cost
Lowering cost
Increasing desirable product differentiation, increase profit margins - Favourable industry & macro-economic conditions
Creating and/or exploiting growth opportunities - Improving governance
Aligning managers’ interests with investors’ interests
Better protection of investors’ rights
According to Warren Buffet why is security selection not worthwhile?
Diversification is protection against ignorance, it makes little sense for those who know what they’are doing.
What is Benjamin Graham opinion of Security valuation
I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities.
This was a rewarding activity, say, 40 years ago; but the
situation has changed a great deal since then.
To that extent I’m on the side of the ‘efficient market’ school of thought now generally accepted by the professors
What is the difference between passive and activist investors
Passive investors attempt to identify misvalued assets
engage in market timing from available information. Intense competition; no reason to expect to earn abnormal
or risk-adjusted returns
Activist” investors attempt to influence factors that
affect the value of the company.
If the influence is positive, value is increased Sharif Andrawes writes valuation reports for active investors. He takes into account the changes they expect to make.
