Investment Valuation Ch.3-4

Front 1

An Abiding Belief in Book Value as the Best Estimate of Value:

Back 1

Accounting estimates of
asset value begin with the book value. Unless a substantial reason is given to do
otherwise, accountants view the historical cost as the best estimate of the value of an
asset.

Front 2

A Distrust of Market or Estimated Value

Back 2

When a current market value exists for an
asset that is different from the book value, accounting convention seems to view this
market value with suspicion. The market price of an asset is often viewed as both much
too volatile and too easily manipulated to be used as an estimate of value for an asset.
This suspicion runs even deeper when values are is estimated for an asset based upon
expected future cash flows

Front 3

A Preference for under estimating value rather than over estimating it

Back 3

When there is
more than one approach to valuing an asset, accounting convention takes the view that
the more conservative (lower) estimate of value should be used rather than the less
conservative (higher) estimate of value. Thus, when both market and book value are
available for an asset, accounting rules often require that you use the lesser of the two
numbers.

Front 4

Return on Assets (ROA)

Back 4

The return on assets (ROA) of a firm measures its operating efficiency in generating profits from its assets, prior to the effects of financing.

Front 5

Return on Capital (ROC)

Back 5

Useful measure of return relates the operating income to the capital invested
in the firm, where capital is defined as the sum of the book value of debt and equity.

Front 6

Return on Equity (ROE)

Back 6

Return on equity (ROE) examines profitability from the perspective of the equity investor by relating profits to the equity investor (net profit after taxes and interest expenses) to the
book value of the equity investment.

Front 7

Current Ratio

Back 7

The current ratio is the ratio of current assets (cash, inventory, accounts receivable) to its current liabilities (obligations coming due within the next period).

Front 8

Quick Ratio

Back 8

The quick or acid test ratio is a variant of the current ratio. It distinguishes current assets that can be converted quickly into cash (cash, marketable securities)

Front 9

Turnover ratios

Back 9

Turnover ratios measure the efficiency of working capital management by looking at the relationship of accounts receivable and inventory to sales and to the cost of goods
sold.

Front 10

Turnover ratios (2)

Back 10

similar pair of ratios can be computed for accounts payable, relative to purchases.

Front 11

Interest Coverage

Back 11

The interest coverage ratio measures the capacity of the firm to meet interest payments from pre-debt, pre-tax earnings.

Front 12

Debt ratio

Back 12

Debt ratios measure the capacity whether the Company can pay the principal on outstanding debt

Front 13

Differences in accounting standards and practices

Back 13

Differences in accounting standards across countries affect the measurement of
earnings. These differences, however, are not so great as they are made out to be and they
cannot explain away radical departures from fundamental principles of valuation12.

Front 14

Why diversification reduces or, at the limit, eliminates firm specific risk

Back 14

Each investment in a diversified portfolio is a much smaller percentage of that portfolio than
would be the case if you were not diversified. Thus, any action that increases or decreases
the value of only that investment or a small group of investments will have only a small
impact on your overall portfolio

Front 15

Portfolio (expected return, variance in return)

Back 15

The expected returns and variance of a two-asset portfolio can be written as a function of these inputs and the proportion of the portfolio going to each asset.

Front 16

Portfolio (covariance)

Back 16

The higher the correlation in returns between the two assets, the smaller are the potential benefits from diversification

Front 17

CAPM assumptions

Back 17

- there is no transaction cost;

- all assets are traded and investments are infinitely divisible;

- everyone has access to the same information

- there exists a riskless asset, where the expected returns are known with certainty

- investors can lend and borrow at the same riskless rate to arrive at their optimal allocations

Front 18

Beta formula

Back 18

Front 19

Arbitrage Pricing Theory (APT)

Back 19

APT- is an alternative of CAPM based on the law of one price Ross (1976)

- uses less restrictive assumptions than CAPM

- require than return on any stock be linearly related to a set of indexes (multi-indexes model)

- it doesn't tell us what the indexes should be (for CAPM - return on market)

Front 20

APM 2 types of risks

Back 20

R is the actual return, E(R) is the expected return, m is the market-wide component of unanticipated risk and e is the firm-specific component

Front 21

APM - market risk

Back 21

The CAPM assumes that market risk is captured in the market portfolio, whereas the arbitrage pricing model allows for multiple sources of market-wide risk and measures the sensitivity of investments to changes in each source.

Front 22

APM - market risk (formula)

Back 22

bj = Sensitivity of investment to unanticipated changes in factor j
Fj = Unanticipated changes in factor j

Front 23

Multi-factors models

Back 23

Multi-factor models, like the arbitrage pricing model, assume that market risk can be captured best using multiple macro economic factors and betas relative to each.

Unlike the arbitrage pricing model, multi factor models do attempt to identify the macro economic factors that drive market risk.

Front 24

Differentiating between Rewarded and Unrewarded Risk

Back 24

Risk that is specific to investment (Firm Specific) - Can be diversified away in a diversified portfolio

1. Each investment is a small proportion of portfolio; 2. Risk averages out across investments in portfolio

Risk that affects all investments (Market Risk) - Cannot be diversified away since most assets are affected by it.

The marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk willbe rewarded and priced

Front 25

Measuring Market Risk - The CAPM

Back 25

If there is
1. no private information
2. no transactions cost
The optimal diversified portfolio includes every
traded asset. Everyone will hold this market portfolio

Market Risk = Risk added by any investment
to the market portfolio

Beta of asset relative to Market portfolio (from
a regression)

Front 26

Measuring Market Risk - The APM

Back 26

If there are no arbitrage opportunities
then the market risk of any asset must be
captured by betas relative to factors that
affect all investments.
Market Risk = Risk exposures of any asset to market factors
Betas of asset relative to unspecified market
factors (from a factor analysis)

Front 27

Measuring Market Risk - Multi-Factor Models

Back 27

Since market risk affects most or all investments, it must come from macro economic factors.
Market Risk = Risk exposures of any
asset to macro economic factors.
Betas of assets relative to specified macro
economic factors (from a regression)

Front 28

Measuring Market Risk - Proxy Models

Back 28

In an efficient market, differences in returns
across long periods must be due to market risk
differences. Looking for variables correlated with returns should then give
us proxies for this risk.
Market Risk = Captured by the Proxy Variable(s).

Equation relating returns to proxy variables (from a regression)

Front 29

Critique of APM and Multi-factors model

Back 29

Extension to multiple factors does become more of a problemwhen we try to project expected returns into the future, since the betas and premiums of each of these factors now have to be estimated. Because the factor premiums and betas are themselves volatile, the estimation error may eliminate the benefits that could be gained by moving from the CAPM to more complex models.

Front 30

Critique of Proxy models

Back 30

The regression models that were offered as an alternative also have an estimation problem, since the variables that work best as proxies for market risk in one period (such as market capitalization) may not be the ones that work in the next period.

Front 31

The Determinants of Default Risk

Back 31

The default risk of a firm is a function of two variables. The first is the firm’s capacity to generate cash flows from operations and the second is its financial obligations – including interest and principal payments.

The default risk is also affected by the volatility in these cash flows

Front 32

Bond Ratings

Back 32

The most widely used measure of a firm's default risk is its bond rating, which is generally assigned by an independent ratings agency.

The two best known are Standard and Poor’s and Moody’s. Thousands of companies are rated by these two agencies and their views carry significant weight with financial markets