Investment Valuation - Ch.1-2

Front 1

"bigger fool" theory of investing

Back 1

Value of an asset is irrelevant as long as there is a "bigger fool" around wiling to buy the asset from them

Front 2

"perception" concept of valuation

Back 2

Value is in the eye of the beholder, any price can be justified if there are other investors wiling to pay that price

Front 3

"based on CF" concept of valuation

Back 3

Price that is paid for the asset should reflect CFs it is expected to generate

Front 4

Myth 1: "Valuation models are quantitative - valuation is objective"

Back 4

Models used in valuation are quantitative, but the inputs leave plenty of room for subjective judgments

Front 5

Reducing the bias in the process of valuation

Back 5

1. Avoid taking strong public position on the value of the firm before the valuation is complete
2.Minimize, prior to the valuation, the stake we have in whether the firm is under or overvalued.

Front 6

Equity research analyst bias

Back 6

More likely to issue "buy" rather then "sell" recomendation.
Due to:
- difficulties of obtaining access and colletction information;
- presure that they face from portfolio managers

Front 7

Self-valuation bias

Back 7

Self valuation done by the target firm in takeover is likely to be positively biased.

Front 8

Myth 2: A well-researched and well-done valuation is timeless

Back 8

In some cases, new information can affect the valuations of all firms in a sector. Information about the state of the economy and the level of interest rates affect all valuations in an economy

Front 9

Myth 3: A good valuation provides a precise estimate of value

Back 9

The degree of precision in valuations is likely to vary widely across investments. The valuation of a large and mature company, with a long financial history, will usually be much more precise than the valuation of a young company, in a sector that is in turmoil.
The problems are not with the valuation models we use, though, but with the difficulties we run into in making estimates for the future.

Front 10

Myth 4: The more quantitative a model, the better the valuation

Back 10

1. You do not use more inputs than you absolutely need to value an asset.
2. There is a trade off between the benefits of building in more detail and the estimation costs (and error) with providing the detail
3. Models don't value companies: you do

Front 11

Myth 5: To make money on valuation, you have to assume that markets are inefficient

Back 11

Those who believe that markets are inefficient should spend their time and resources on valuation whereas those who believe that markets are efficient should take the market price as the best estimate of value.
Pre-condition for market efficiency seems to be the existence
of millions of investors who believe that markets are not.

Front 12

Myth 6: The product of valuation (i.e., the value) is what matters; The process of valuation is not important.

Back 12

The process can tell us a great deal about the determinants of value and help us answer some fundamental questions - What is the appropriate price to pay for high growth? What is a brand name worth?

Front 13

Valuation by Fundamental Analysts

Back 13

Value of the firm can be related to its financial characteristics - its growth prospects, risk profile and cashflows. Any deviation from this true value is a sign that a stock is under or overvalued
Main assumptions:
(A) the relationship between value and the underlying financial factors can be measured.
(B) the relationship is stable over time.
(C) deviations from the relationship are corrected in a reasonable time period.

Front 14

Valuation by Franchise Buyer

Back 14

"We try to stick to businesses we believe we understand," Mr. Buffett writes. Franchise buyers concentrate on a few businesses they understand well, and attempt to acquire undervalued firms.
Main assumptions:
(a) Investors who understand a business well are in a better position to value it correctly.
(b) These undervalued businesses can be acquired without driving the price above the true value.

Front 15

Valuation by Chartists

Back 15

Chartists believe that prices are driven as much by investor psychology as by any underlying financial variables. The information available from trading - price movements, trading volume, short sales, etc. - gives an indication of investor psychology and future price movements.
Main assumptions:
A) Prices move in predictable patterns, that there are not enough marginal investors taking advantage of these patterns
to eliminate them,
B) Average investor in the market is driven more by emotion
rather than by rational analysis.

Front 16

Valuation by Information Traders

Back 16

Information traders attempt to trade in advance of new information or shortly after it is revealed to financial markets, buying on good news and selling on bad. The focus is on the relationship between information and changes in value, rather than on value
Main assumptions:
A) Traders can anticipate information announcements and gauge the market reaction to them better than the average investor in the market

Front 17

Valuation by Market Timers

Back 17

That it is easier to predict market movements than to select stocks and that these predictions can be based upon factors that are observable.Valuation of individual stocks may not be of any use to a market timer

Market timing strategies can use valuation in at least two ways:
(a) The overall market itself can be valued and compared to the current level.
(b) A valuation model can be used to value all stocks, and the results from the crosssection can be used to determine whether the market is over or under valued.

Front 18

Valuation by Efficient Marketers

Back 18

Market price at any point in time represents the best estimate of the true value of the firm, and that any attempt to exploit perceived market efficiencies will cost more than it will make in excess profits.
They assume that markets aggregate information quickly and accurately. Valuation is a useful exercise to determine why a stock sells for the price that it does

Front 19

Approaches to valuation

Back 19

1. Discounted Cashflow Valuation, relates the value of an asset to the present value of expected future cashflows on that asset
2. Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable such as earnings, cashflows, book value or sales
3.Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

Front 20

Basis for Discounted Cashflow Valuation

Back 20

Where,

n = Life of the asset

CFt = Cashflow in period t

r = Discount rate

Front 21

Types of DCF valuations

Back 21

Equity Valuation - value just the equity stake in the business,

Firm Valuation - value the entire firm, which includes, besides equity, the other claimholders in the firm

Adjusted Present Value (APV) Valuation - value the firm in pieces, beginning with its operations and adding the effects on value of debt and other non-equity claims.

Front 22

Difficulties with DCF - "Firms in trouble"

Back 22

For firms that are expected to survive, CFs will have to be estimated until they turn
positive, since obtaining a present value of negative CFs will yield a negative value
for equity or the firm.

Front 23

Difficulties with DCF - "Cyclical Firms"

Back 23

CFs of cyclical firms tend to follow the economy - rising during economic booms and falling during recessions.

Estimating future cashflows then becomes entangled with analyst predictions about when
the economy will turn and how strong the upturn will be.

Front 24

Difficulties with DCF -"Firms with unutilized assets"

Back 24

If a firm has assets that are unutilized (and hence do not produce any cashflows), the value of these assets will not be reflected in the value
obtained from discounting expected future CFs

Front 25

Difficulties with DCF - "Firms with patents or product options"

Back 25

Firms often have unutilized patents or licenses
that do not produce any current CFs and are not expected to produce CFs in the near future, but, nevertheless, are valuable.

If this is the case, the value obtained from
discounting expected CFs to the firm will understate the true value of the firm.

Front 26

Difficulties with DCF - "Firms in the process of restructuring"

Back 26

Firms in the process of restructuring often sell
some of their assets, acquire other assets, and change their capital structure and dividend
policy. Some of them also change their ownership structure (going from publicly traded to private status) and management compensation schemes. Each of these changes makes estimating future CFs more difficult and affects the riskiness of the firm.

Front 27

Difficulties with DCF - "Firms involved in acquisitions"

Back 27

1. Synergy in the merger and if its value can be estimated. It can be done, though it does require assumptions about the form the synergy will take and its effect on CFs

2. Effect of changing management on CFs and risk. Again, the effect of the change can and should be incorporated into the estimates of future CFs and discount rates and hence into value

Front 28

Difficulties with DCF - "Private Firms"

Back 28

The biggest problem in using discounted CFs valuation models to value private firms is the measurement of risk (to use in estimating discount rates), since most risk/return models require that risk parameters be estimated from historical prices on the asset being analyzed

Front 29

Relative Valuation

Back 29

The value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, CFs,
book value or revenues

Models:

A) industry-average price-earnings ratio;

B) price to book value ratio;

C) multiple of price to sales;

D) price to cashflows;

E) price to dividends;

F) market value to replacement value (Tobin's Q)

Front 30

Contingent Claim Valuation

Back 30

A contingent claim or option pays off only under certain contingencies - if the value of the underlying asset exceeds a pre-specified value for a call option, or is less than a pre-specified value for a put option.

Front 31

Payoff Diagram on Call and Put Options

Back 31

Front 32

Limitations in using option pricing models

Back 32

1) constant variance and dividend yields for options with long lifetimes;

2) underlying asset is not traded - inputs for the value of the underlying asset and the variance in that value cannot be extracted from financial markets and have to be estimated