week 8

Question 1

 Misconceptions about valuation

Answer 1

o Myth 1: A valuation is an objective search for true value
 All valuations are subjective
 Trading occurs because no one can agree on the true value of an asset
• Different opinions
 Insider trading
• If people begin systematic trading -> people will stay away from the market

o Myth 2: A good valuation provides a precise estimate of value
 There are no precise valuations
 Payoff to valuation is greatest when most uncertain
 A greater probability of a price being wrong -> adjustment of prices later
• More profits
 Need to identify the relevant factors

o Myth 3: More quantitative models are better
 Ones understanding of valuation model is inversely proportional to the number of inputs
 Simpler valuation models often perform better

Question 2

 IBM versus STD oil of NJ

Answer 2

o The price matters
o The over-value or the undervaluing of the company matters
o Everyone believed IBM would do better than STD oil, however because everyone believed this -> over-valued IBM and undervalued standard oil
 Investors paid more for IBM because they believed it would do better
o Representative Bias
 Look at it in-terms of good value of money

Question 3

 Framework for analysis of company value

Answer 3

o	Firm competitiveness
	Cost of production
	Product differentiation
	Quality of management
o	Industry Attractiveness
	Barriers to entry
	Leverage capacity

Question 4

 How do macroeconomic settings affect equity returns?

Answer 4

o Principally through changes in the discount rate, E(R), which is affected by economic policy
o Markets move based on shifts in conditions relative to the conditions that they are priced in
 The definition of a surprise
 Greater the discrepancy -> larger the surprised
• E.g. Nixon Rally
o A commercial property is like a bond, a little bit riskier than a bond but similar

Question 5

 Implications for investors

Answer 5

o Discount rates reflect the cost of money which affects the value of assets
o Unexpected changes in the cost of money affect the value of assets
o Investors can choose to try to anticipate changes in interest rates and profits from these changes
 Or they can choose assets in their portfolio to hedge against changes

Question 6

 What is the relationship between economic growth and equity returns?

Answer 6

o Share market indices rising = encourage and vice versa?
o Should we be concerned about the value of equities if there is a recession?
o Economists predict recessions more often than they happen
 Speculative and its random/luck
 People prefer to believe things are bad than they are good

Question 7

 Two factors mediate the link between economic growth and share price

Answer 7

o Policy response to changing economic conditions
 E.g. fiscal policy – stimulus package
 Monetary policy – interest rates lowered
o Economic growth doesn’t necessarily translate into higher profits
 Profitability is a function of competitive pressure

Question 8

 Distributional effects of QE

Answer 8

o Not everyone gains from QE
o Households owning low risk financial assets / real assets perceived to be low risk gain
o Expectation is that eventually riskier asset classes also get access to capital which, in turn, stimulates demand
 Rich get richer

Question 9

 What do central banks do when the risk-free interest rate is at / below 0

Answer 9

o	Liquidity trap
o	People keep buying government bonds
	Bond prices increase
	ROR decreases
	Equities become cheaper, ROR on equities increase

Question 10

 Economic growth and share prices

Answer 10

o Share prices react to unexpected changes in economic growth
o In the long-run, economic growth is largely irrelevant to forecasting share prices
o The key factor linking economic growth and share prices is the proportion of profit from economic growth that is captured by existing shareholders

Question 11

 Economic growth and equity returns

Answer 11

o Over saturation in the market
o E.g. booming video store industry -> many competitors entering -> profit margins decrease
o Create for consumers but bad for producers
o What matters is the number of competitors, not the industry growth
o Margins being squeezed, pricing power is non-existent

Question 12

 Who benefits from increased productivity

Answer 12

 Providers of capital (investors get higher dividends)
 Labour (workers get higher wages)
 Consumers (lower prices and higher quality goods)
o How these gains are distributed is a function of supply and demand and political influence

Question 13

 Economic growth has an impact on growth options

Answer 13

o When high economic growth is expected, investors value companies making investments that can capture the profits from that growth