Equity Valuation and Analysis

Equity valuation & Analysis By Bhargav Buddhadev MMS Finance Roll Number 9

Serial Number 1 2 3 4 5 6

8 9

Particulars Introduction Active Investment styles Sub categories of active equity management styles Equity valuation models Valuation models for cyclical stocks Models based on price ratio analysis Price equity ratio Price cash flow ratio Price sales ratio Price book ratio Valuation equations Random valuation model Intrinsic value Market anomaly returns Capital asset pricing model Strategies Bibliography

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Equity Valuation and Analysis

Introduction
The security analyst when faced with the problem of a buy or sell decision must first evaluate the past performance of the security, and then coupled with his personal experience predict the future performance of the security and the relative market position. The amount of data available to him far exceeds his potential and therefore he has to base his predictions on several basic attributes and modify the results in the light of intuitive beliefs. While the process may be successful, its intuitive segments make the evaluation of errors and improvements of this technique very difficult, if not impossible.

Equity valuation is difficult in comparison to valuation of bonds and preference shares. This is because benefits are generally constant and reasonably certain. Equity on the other hand involves uncertainty. It is the size of the return and the degree of fluctuations, which in togetherness determine the values of the share of the investor. Therefore forecasting abilities of the analyst are more crucial in the equity analysis. Infact equity analysis is based on the notion that the stock market is not working efficiently. In other words active management is based on the notion that historical and current information is not fully and correctly reflected in the current price of the stock. Hence there exist stocks that are over valued and those that are under valued. The task of the equity manager is to decide which stocks are which and then invest accordingly. By contrast the equity manager who believes that the market is efficient tends to flow a passive strategy. With indexing being the most common form of equity strategy.

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Equity Valuation and Analysis

Active Equity Investment Styles:

The primary style of active equity management style is top down and bottom up. The manager who uses top down style begins with an overall economic environment and a forecast of its nearest outlook and makes a general asset allocation decision regarding the relative attractiveness of the various sectors of the financial markets (e.g. equity, bonds, real estate, bullion etc). The manager then analyses the stock market in an attempt to identify economic sectors and the industries that stand to gain or lose fro the managers economic forecast. After identifying attractive and unattractive sectors and industries, the top down manager finally selects the portfolio of individual stocks.

The process is represented in the figure given below; Economic forecast

Financial markets
Asset allocation

Stock markets
Sector analysis

Other asset markets

Equity portfolio

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Equity Valuation and Analysis

A manager who uses bottom up equity approach de-emphasizes the significance of economic and market styles and focuses instead on the analysis of individual securities. Using financial analysis and computer screening techniques, the bottoms up manager seek out stocks that have certain characteristics that are deemed attractive (e.g. low price earning ratio, small capitalization, low analyst coverage etc)

Sub categories of active equity management

Some of the major sub categories of the two major style of active equity management are listed below;

Growth managers: Growth managers can be classified as either top-down or bottom up. The growth managers are either divided into large capitalization or small capitalization. The growth managers buy securities that are typically selling at relatively high P/E ratios, due to high earnings growth rate, with the expectation of continued high earnings growth. The portfolios are characterized by high P/E ratios, high returns, and relatively low dividend yields.

Market timers: The market timer is typically a set category of top- down investment style and comes in many varieties. The basic assumption is that he can forecast the market i.e. when it will go up or down. In the sense he market timer is not too distant than the technical analyst. The portfolio is not fully invested in

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Equity Valuation and Analysis equities. Rather he/she moves in and out of the market depending on the economic, technical and analytical skills he/she dictates.

Hedgers: The hedger seems to buy equities but also to place well-defined limits on the investors investment limits. One popular hedging technique involves simultaneously purchasing a stock and put option on that stock. The put option sets a floor on the amount of loss that one can make (if the stock process go down) while the potential profit (if the stock prices go up) is diminished only by the original cost of the put. This is an example of the relatively simple hedge. Value managers: These are sometimes referred to as contrarians. This is because they sometimes see value where many other market participants dont. These buy securities that are available at a discount to the face value and sell them at or in excess of that value. They can fall into either the top down or bottoms up approach. Value managers use dividend discount.

Group rotation managers: The group rotation manager is in the sub category of the top down management style. The basic idea behind this technique is that the economy goes through reasonably well-defined phases of the business cycle, namely, recession, recovery, expansion and credit crunch. The group rotator believes that he can discern the current phase of the economy and forecast as to which phase is going to evolve. He can then select those sectors and economies that are going benefit. For example if the economy were perceived to be on the verge of moving from recession to recovery, the group rotator would begin to

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Equity Valuation and Analysis purchase stocks in the appropriate sectors and specific industries that are sensitive to the pick up in the economy. Technicians: They discern market cycles and pick up securities solely on the basis of historical price movements as they related to the projected price movements. By reading a chart and artfully discerning patterns, the technician hopes to be able to predict the future path of the price action models P/E, earning surplus etc. In terms of characteristics, value managers have relatively low betas, low price book and P/E ratios and high dividend yields.

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Equity Valuation and Analysis

Equity valuation models

The purpose of these models is to identify whether the stock is overpriced or under priced. Under priced stocks need to be purchased and over priced stock need to be shorted?

Present value estimation: It is simply the inverse of future value. If we know the cash flows that we are going to get in the future course and the interest rate then we can discount the same and get the present value. Formula = Future value (1+I)^n Let us consider an example. Suppose we have an opportunity to receive 100 a year from now. Now if the interest rate is 12% then the present value shall be 100 (1+.12)^1 = 89.28

In order to develop a consistent system of security valuation theorem, it has become fashionable to apply the techniques of present value theory to the equity valuation. Let us assume there is an investor whose cost of capital is k and decides to invest in a company. As a first step he calculates the adjusted earnings per share over the past few years and examines the stability of earnings and their

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Equity Valuation and Analysis growth and on the basis of these findings and of a companys outlook derives an estimate of the future earnings of the company. For convenience let us assume that the future earnings is E, that these earnings will continue indefinitely into the future. What is the value of such a share to this particular investor?

Given the data the value can be calculated as below;

V = E + E +. E (1+k) (1+k)^2 (1+k)^t Thus in this manner the expected stream of earnings, capitalized at the investors cost of capital measures the intrinsic value of the share. Now we compare this valuation with the current stock price (P). Now if V-P>0 then the stock is under priced therefore the investor should purchase it and if it is <0 then it is over priced and therefore the investor should sell it.

Different investors can be expected to evaluate the investments differently. Some will decide to buy the equity while others will decide to sell the equity if they already sell now. This differential behaviour reflects two principal factors; a) Different individuals have different cost of capital so that calculation using one discount rate may result in negative NPV while the use of other discount rate may be give a positive NPV.

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Equity Valuation and Analysis b) Even if both investors have the same cost of capital, differences in their estimates of the firms profitability decisions. Basic model: One of the most used equity valuation model is the dividend discount model. In its simplest form, the DDM defines the intrinsic value of a share as the present value of future dividend. These are several variations of the DDM because of different assumptions about the growth rate of dividend and its relationship to the discount rate used to calculate present values. may result in different investment

Zero growth models: The most basic of all the DDS is the zero growth model. This model assumes that the dividend will be constant over time, so that growth is zero, and that the investors required rate of return is constant.

Constant growth model: In this model cash dividends are expected to grow at the constant rate. In order to find the discounted present value of the stream of constantly rising dividends, the investors can use the equation of constant growth of dividends.

Value = D1 Ke-g This equation tells us that the value of an equity share is equal to the cash dividend in time period 1 discounted by the difference between the required rates of return required by equity investors and growth rate of dividends. In

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Equity Valuation and Analysis using this equation the value of dividend anticipated in the coming year is to be taken. For example if an investor has a share whose current cash dividend at time 0 is 4, the constant growth rate of dividend is15% per year and the required rate of return is 20%, the value of this share will be

Value =

4(1+.15) .20-.15 = 92

Note that the current price of Rs. 92 is much higher than the Rs.20 where no growth in future cash dividends was assumed. This is expected since, other things remaining equal, an investor would value a growing cash flow stream at a higher rate than a non-growing stream.

Variable growth rate of dividend: Consider a firm grows at a faster rate for a few years and then reverts to a constant growth rate or no growth situation. This might occur if the firm has made previous investments that produced high cash flows, but increasing competition is expected to reduce the future growth rate. In this case the value of a firm whose growth rate of dividends varies over time can be determined by the following equation;

Value =

Do (1+gx)^t (1+k)^t

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Equity Valuation and Analysis Where gx = growth rate of dividend for n years.

This equation can be expended any number of times, the ability to change growth rates allows one to value a share over the life cycle of the firm on the rates of growth change. If the growth rate of dividends is expected to grow at one rate for a period of time and then a constant growth rate of dividend, the equation model is;

Value =

Do(1+gx)^t + Dn+1 (1+k)^t (k-gy)

[ 1 ] (1+k)^n

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Equity Valuation and Analysis To illustrate the use of this multiple growth rate dividend valuation method, consider the case of this hypothetical company XYZ. The company paid its first cash dividend of Rs.2.5 today and dividends are expected to grow at the rate of 30% for the next 3 years. Thereafter cash dividends are expected to grow at the rate of 10%. Further the shareholders are expecting 15% rate of return.

Solution: First we shall calculate the present value of dividends for the first 3 years;

Year (1) 0 1 2 3

Dividend Do(1+gx)^t (2) 2.5 3.25 4.225 5.493 SUM =

Capitalization rate (3) .870 .756 .658

Present value (4)=(2)*(3) 2.8275 3.1941 3.6140 9.6356

Step 2 Value at the end of the 3rd year for the remaining life of the company will be;

D3 (1+gx) = 5.493(1+.10)=6.0423

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Equity Valuation and Analysis Therefore value at the end of the third year V3 = 6.0423 (.15-.10) = 120.846 Therefore the present value is 120.486* .658 =79.2797

Thus the value of the share is 9.6356 +79.2797 = 88.9153

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Equity Valuation and Analysis

Valuation models for cyclical stocks:

Bauman used as well as Clendenin, the present value concept of arriving at the stock value by discounting at an appropriate yield rate all the future cash flows. He spells the factors that determine the future dividend income, namely the growth rate and the growth duration, and argues that a company with a growth rate in excess of the average shown in an industry will sooner or later finds its growth rate declining to the average shown in an industry. How long this transition period lasts depends on the company, industry, product, competition etc A guide to follow is to determine the probable position of the company in its life cycle. For example, if a company has been experiencing an abnormally high growth rate, Bauman suggests that, unless there is a sufficient evidence to the contrary, the best earnings and dividend projection is probably based on a decreasing rate of growth, until it eventually approximates the secular growth rate for the majority of the companies in the company. For reasons of convenience he makes an assumption in his model that the growth rate will decline by equal amounts over the span of the transitional period.

According to him in order to make a good estimate of future dividends, the investor must ascertain (a) the current growth rate of dividend (b) how long will it take until the growth rate has declined to the average typical for the majority of corporations.

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Equity Valuation and Analysis Once the investor has determined the pattern of future dividend incomes he must discount them to arrive at the present value. What shall be the discount rate? Bauman offers guidelines from 6 to 10 percent depending on the risk involved.

The discount rate applied to the first years dividend is the lowest, and it increases with time as the distant years become more and more uncertain. That is the risk premium added to the discount rate increases with time. Although he does not tell the investor how much higher future discount rate must be taken, but he gives a very strong clue by showing what rates were representative of majority stock exchanges. Bauman relies a lot on historical data and believes this action is justified by absence at present of any indicators, which point to large changes ahead. He reminds investors to be on guard constantly to recognize signs of changes.

Obviously the cyclical model is difficult to formulate even on simple configuration, but it does point out the variables that must be considered. Let us assume that a stock has 4 years business cycle from trough to peak to trough, that the stock pays a regular dividend, and that the investor is willing to trade in and out of the stock but since the risks are great he must earn a 20% rate of return rather than a 10% Now if D1 is 1 and D2 is 1.8 and P2 is 80, the present value of the stream of income at 20% is

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Equity Valuation and Analysis Value =1 + 1.8 (1+1.2) (1+1.2)^2 = 57.08 Therefore, if the stock is available at lower than 57.08 then it would provide the speculative investor with a yield of over 20%. But what valuation model should we follow if the speculative investor wished to continue trading in shares, did not wish to sell short, and therefore was temporarily out of the market. May be his funds were placed in the savings bank.

= D1 +D2+CG2 +I3 +D4 +D5 + D6+P6 (1+k) (1+k)^2 (1+k)^3 (1+k)^4 (1+k)^5 (1+k)^6

Where CG2 is the capital gain in year 2, I3 and I4 are interest income and D1 , D2 are dividends. The equation covers a successful trade from the purchase of stock at the cyclical low, then to sale at the high and a move to a say 8% savings account then to repurchase at a low, and a final sale at a peak in year 6. It is obvious that this is difficult to do in practice and that the cycle might be substantially shorter than six years.

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Equity Valuation and Analysis

Model based on price ratio analysis

1. Price earning ratio
The most popular ratio used to assess the value of the equity is the companys price equity ratio abbreviated as P/E ratio. It is calculated as the ratio of the firms current stock price divided by the earnings per share (EPS). The inverse of the p/e ratio is referred to as the earnings yield. Clearly the price earning and the earnings yield are required to measure the same thing. In practice earnings yield less commonly stated and used than P/E ratios. Since most companies report earnings each quarter annual earnings per share can be calculated as the most recently quarterly earnings per share times four or as the sum of the last four quarterly earnings per share figures. Most analysts prefer the first method of multiplying the latest quarterly earnings per share value time four. However the difference is usually small, but it can sometimes be source of confusion. Analysts often refer to high P/E stocks as growth stocks. To see why notice that a P/E ratio is measured as a current stock price over current earnings per share. Now consider two companies with the same current earnings per share , where one company is a high growth company and the other is a low growth company. Which company should have a higher stock price, the high growth company or the low growth company? The question is a no brainer. These entire equal, we would be surprised if the high growth company did not have a higher stock price and therefore a higher P/E ratio. In general companies with higher expected earnings will have higher P/E ratio, which is why P/E stocks are referred to as the growth stocks.

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Equity Valuation and Analysis The reason why they are referred to high growth stock is simple. The reason is that low P/E value stocks are often viewed as cheap relative to current earnings. This suggests that these stocks may represent good investment values, and hence the term values stocks. However it should be rated that the term growth stock and value stock are most justly commonly used labels. Of course only time will tell whether a low P/E stock is of good value. The P/E ratio used in the valuation equation is influenced by i) P/E ratios for a group of companies tend to change little from one period to the next. Therefore an investor cannot expect a dramatic change in the future P/E ratios. The future level of the P/E ratio can be viewed as the function of the current P/E ratios or the average P/E ratio over the same period of time. ii) The P/E ratio is a function of future expected earnings the higher the growth rate of earnings the higher will be the P/E ratio. An investor will be willing to pay a higher price forth-current earnings if the earnings are expected to grow at a much higher rate. iii) A normal P/E for the market is difficult to determine. A normal P/E ratio is established for each company but it can be compared to the market P/E to give some idea of risk. The higher the P/E ratio the higher is the risk. This is true inspite of the fact that the investors are ready to pay more. iv) v) vi) vii) Inflationary conditions tend to reduce the P/E ratios. P/E ratios vary by the industry Higher interest rates tend to reduce the P/E ratios P/E ratios vary by the industry

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Equity Valuation and Analysis viii) An investor should examine the trend of the P/E ratio over time for each company. ix) x) xi) xii) xiii) xiv) The level of P/E ratio is not an absolute one but a relative one. Speculative companies and cyclical companies tend to have a lower P/E Growth companies tend to have a higher P/E Companies with larger portion of debt tend to have a lower P/E A company that tends to pay a higher dividend tend to have a higher P/E P/E ratios can change radically and suddenly because of change in the expected growth rate of earnings. Therefore the greater the expected stability of the growth rates the higher the P/E ratio. How can the P/E ratio be used as guide in making an investment decision? For this the analyst is to apply various rules of thumb on companys earnings selecting an appropriate P/E ratio to determine the value of its shares. The resulting price is to be compared with current market price to assess the relative magnitude of the ratio. Taken from the historical record of the equity in question the determination of the current

equity must be followed by a standard of comparison. For this the analyst mat ascertain the median or the mean P/E for the equity as well as its range over the time. More weight can be given to the recent past. This provides boundaries within which the P/E must fall and indicates whether the equity is tending to sell at the upper limits of expectation or the lower limits. Industry P/E provide the guidelines, however the different companies in the same industry frequently carry different P/Es.

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Equity Valuation and Analysis Robert Ferguson presents a method of determining justifiable price earnings ratio for growth stocks as compared to the standard. His objectives are to answer the following questions: A) How many years of the present high growth rate are assumed by todays market price before the growth rate of the company drops to the standard rate? B) What price earning ratio is justified given a certain growth rate which is higher than the standard rate for a certain number of years ? Ferguson takes the market price as a base and then determines what estimates of the basic factors the market makes. He then leaves the investors to decide whether these estimates are too low or too high in his judgement. Ferguson develops a nomograph which eliminates the need for complicated calculation on the part of the investor. The nomograph is a graphical solution to the equation. Pa = (1+Ra)^n P1a Where Pa = some standard price earning ratio (1+Rb)^n

P1a = growth stock price earning ratio Ra Rb = standard growth rate assumed = rate of growth assumed for growth stock

Although it appears that Ferguson ignores the discount rate, closer examination reveals that the use of the standard growth rate in the denominator of his equation, implies that the investors will apply uniform discount rates to all equity earnings and that difference

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Equity Valuation and Analysis in price/ earnings ratio arise only from the differences in assumed growth rates and duration. A further assumption is made implicitly that the quoted growth rate stays on the same level until period t and then drop off suddenly to a rate equivalent to the standard rate. An analysis based on the foregoing assumption differs ofcourse very strongly from Bausans Variable growth rate. That assumes evenly declining growth rates and increasing discount rates for income with longer futurity.

In the last paragraph Ferguson states We have not considered the fact that many stocks pay dividend which are an important source of profit in addition to the price appreciation. This is especially true in situations where the growth rate is of the same order of magnitude as the dividend yield. In these instances the neglect of dividends may well result in incorrect calculation. An approximate adjustment for the dividend income, useful in many instances would be to add the yield to the per share earnings growth rate and use the resultant figure in place of the growth rate This implicitly assumes that the current market price of stock completely disregards dividend payments. Moreover, this procedure would represent double counting and overstate justifiable price/earning ratios for the growth stocks, since dividend payout is already implicitly in the standard price/earnings ratio used in his equation.

Nicholas Molodovsky believes that any standardized selections of future periods, such as 10 years for instanse, cold serve illustrative purpose only. He stressed that in actual

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Equity Valuation and Analysis practice, projections of future earnings trends of different stock would have to be made for whatever varying period might be successfully indicated. The nature of the industry to which a company belongs- as well as the corporations particular characteristicsshould in reality determine both the length of the period for which the earnings are projected into the future and also the delicate process of the splicing with an overall historical date. Depending on each individual case, such a transition may well take the form of mathematical curves with very different graduations of diminishing rates of growth. Such gradual transition can be easily performed by a computer, which could also carry out the valuation formulas requirements of an infinite time horizon. According to him this later condition can be easily met by combining the compound interest formula used for complying a bonds yield maturity with the expression of geometric progression for an infinite number of terms, which constitute a mathematical description of an equities habitual market.

According to him the appropriate rate will take into consideration the risks involved, which are influenced by the growth of earnings or dividend expected in the future, and the expected future price. In short, risk is a function of the variability of return. A higher discount rate will be employed whether the risk is greater and lower one when the risk is lower.

One commonly used approach is based on the multiple growth models and a view that companies typically evolve through 3 stages during their lifetime.

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Equity Valuation and Analysis These stages are 1. Growth stage The stage is characterized by rapidly expanding sales, higher profit margins and abnormally high growth in the EPS. Because the expected profitability of new investment opportunities is high, the payout ratio is generally low. The unusually high earnings enjoyed in this stage attract competitors leading to a gradual decline in the growth stage.

2. Transition stage In the later years of the companys life increased profit saturations begin to reduce its growth rate, and its profit margins come under pressure. Since there are fewer investment opportunities the company begins to payout a large percentage of earnings.

3. Maturity stage Generally, the company reaches a position where its new investment opportunities offer, on average, slightly attractive returns on equity. At that time, its earning growth rate, payout ratio, and average return on equity stabilize for the remaining life of the company. In implementing the multiple growth model the analyst must estimate a number of variables for each security being evaluated. One method involves estimating values for the following variables 1. Expected earnings and dividend for the next five years

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Equity Valuation and Analysis 2. The growth rate of earnings and the payout ratio for the transition stages which is assured to be in year six. 3. The duration of the transition stage--- that is the number of years until the company reaches the maturity stage. 4. Growth patters for the EPS and the payout ratio for the growth stage 5. The combination of the earnings growth rate and payout ratio that provides the desired average return on equity for the next investment during the maturity stage.

Jeeremy C criticizes methods of comparative valuation because they are either base don price / earnings ratio or on price dividend ratios. He argues that, no one approach will give satisfactory results in a wide variety of common stocks because there are two investment reasons for owning common stock dividend income and hope of capital appreciation if the company grows. Thus there really is no sharp dividing line between an income stock and a growth stock.

In this technique two different multipliers are computed, one to be applied to the dividend from one set of factors, and another multiplier from another set of factors to be applied to the earnings retained in the business. The two resultant values are added together in order to obtain the value of equity. The dividend multiplier is based on the assumption that the value of a dividend is a function of the yield on a higher grade, or money rate, etc and the following factors 1. Debt + Preference as % of capital 2. Debt + Preference as % of working capital

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Equity Valuation and Analysis 3. Pay out in % form 4. Total plow back as % of equity.

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Equity Valuation and Analysis

Price cash flow ratio.

Instead of price earning ratio many analysts prefer to look at price cash flow ratio. A price cash flow ratio is measured as the companys current stock price divided by its current annual cash flow per share. There are varieties of definitions of cash flow. In this context, the most famous measure is simply calculated as net income plus depreciation, so this is the one we use here. Cash flow is usually reported in firms financial statement and labeled as cash flow from operations. The difference between cash and earnings is often confusing largely because the way standard accounting practice defines net income. Essentially net income is measured as incomes minus expenses. Obviously this is logical. However not all are actual cash expenses. The most important exception is depreciation. When a firm acquires a long-lived asset such as new factor facility, standard accounting practice does not deduct the cost of the factory at all once, even though it is actually paid for all at once. Instead the cost is deducted over time. These deductions do not represent actual cash payments, however. The actual cash payments occurred when the factory was purchased. Most analysts agree that in examining a companys financial performance, cash flow can be more informative than the net income.

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Equity Valuation and Analysis

Price sales ratio

An alternative view of companys performance is provided by the price sales ratio. A price sales ratio is calculated as the current price of the stocks divided by the current annual sales revenue per share. A high P/S ratio would suggest high sales growth, while a low would suggest sluggish sales growth.

Price book ratio

A very basic price ratio for a company is the price book ratio, sometimes called the market book ratio. A price book ratio is measures as the market value of a companys equity issued divided by the book value of the equity. They are appealing because book value represents, in principle, historical cost. The stock price is an indicator of current book value, so a price book ratio simply measures what the equity is worth today relative to what it costs. A ratio bigger than 1 indicated that the firm has been successful in creating value for its stockholders. A ratio less than 1 indicated that the company has infact lost the value for its shareholders. This interpretation of this ratio seems simple enough, but the truth is that of varied and changing accounting standards, book values are difficult to interpret. For this and other reasons, price book ratios may not have much information as they once did. All the above ratios discussed are commonly used to calculate the estimates of expected future prices. Multiplying a historical average price ratio by an expected future value for the price ratio denominator variable does this.

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Equity Valuation and Analysis

Valuation equations for finding expected returns

To get optimal risk return on an investment, the investors are to find the expected returns. This is done by substituting the current price for equity value and solving return by trial and error basis with the present value or the discount value being found when the present value of inflows matches the current price. To solve the equation and to get the estimates of earnings growth rate, and the price earning ratio expected in year 3 several approaches are given below;

Random valuation model

The random valuation model begins with the premise that the next 3 years growth of earnings dividend and price will be similar to those of 10 years. This is similar to the valuation for estimating the rate of return. In random, the ten-year growth rate of earnings and dividends is used, along with the ten year P/E ratio. But instead of assuming that the 10-year rate will continue in future it is assumed that the rate is unknown but it is likely to be within the value established by the 10-year mean value and the standard deviation around the mean value of its estimate. This applies to each of the variable that is to be substituted into the valuation equation to be solved for r i.e. return. Three variables must be estimated in the valuation equation to establish r. They are expected dividend growth rate, earnings growth rate and the expected P/E ratio in the third year. The value for each variable assumes to be around the historic mean plus one standard deviation of the estimate.

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Equity Valuation and Analysis

Intrinsic value
What Is Intrinsic Value?
The concept of intrinsic value has been characterized above in terms of the value that something has in itself, or for its own sake, or as such, or in its own right. The custom has been not to distinguish between the meanings of these terms, but we will see that there is reason to think that there may in fact be more than one concept at issue here. For the moment, though, let us ignore this complication and focus on what it means to say that something is valuable for its own sake as opposed to being valuable for the sake of something else to which it is related in some way. Perhaps it is easiest to grasp this distinction by way of illustration. Suppose that someone were to ask you whether it is good to help others in time of need. Unless you suspected some sort of trick, you would answer, Yes, of course. If this person were to go on to ask you why acting in this way is good, you might say that it is good to help others in time of need simply because it is good that their needs be satisfied. If you were then asked why it is good that people's needs be satisfied, you might be puzzled. You might be inclined to say, It just is. Or you might accept the legitimacy of the question and say that it is good that people's needs be satisfied because this brings them pleasure. But then, of course, your interlocutor could ask once again, What's good about that? Perhaps at this point you would answer, It just is good that people be pleased, and thus put an end to this line of questioning. Or perhaps you would again seek to explain the fact that it is good that people be pleased in terms of something else that you take to be good. At some point, though, you would have to put an end to the questions, not because you would have grown tired of them (though that is a distinct

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Equity Valuation and Analysis possibility), but because you would be forced to recognize that, if one thing derives its goodness from some other thing, which derives its goodness from yet a third thing, and so on, there must come a point at which you reach something whose goodness is not derivative in this way, something that just is good in its own right, something whose goodness is the source of, and thus explains, the goodness to be found in all the other things that precede it on the list. It is at this point that you will have arrived at intrinsic goodness. That which is intrinsically good is nonderivatively good; it is good for its own sake. That which is not intrinsically good but extrinsically good is derivatively good; it is good, not (insofar as its extrinsic value is concerned) for its own sake, but for the sake of something else that is good and to which it is related in some way. Intrinsic value thus has a certain priority over extrinsic value. The latter is derivative from or reflective of the former and is to be explained in terms of the former. It is for this reason that philosophers have tended to focus on intrinsic value in particular. The account just given of the distinction between intrinsic and extrinsic value is rough, but it should do as a start. Certain complications must be immediately acknowledged, though. First, there is the possibility, mentioned above, that the terms traditionally used to refer to intrinsic value in fact refer to more than one concept; again, this will be addressed later (in this section and the next). Another complication is that it may not in fact be accurate to say that whatever is intrinsically good is nonderivatively good; some intrinsic value may be derivative. This issue will be taken up (in Section 5) when the computation of intrinsic value is discussed; it may be safely ignored for now. Still another complication is this. It is almost universally acknowledged among philosophers that all value is supervenient on certain nonevaluative features of the thing that has value.

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Equity Valuation and Analysis Roughly, what this means is that, if something has value, it will have this value in virtue of certain nonevaluative features that it has; its value can be attributed to these features. For example, the value of helping others in time of need might be attributed to the fact that such behavior has the feature of being causally related to certain pleasant experiences induced in those who receive the help. Suppose we accept this and accept also that the experiences in question are intrinsically good. In saying this, we are (barring the complication to be discussed in Section 5) taking the value of the experiences to be nonderivative. Nonetheless, we may well take this value, like all value, to be supervenient on something. In this case, we would probably simply attribute the value of the experiences to their having the feature of being pleasant. This brings out the subtle but important point that the question whether some value is derivative is distinct from the question whether it is supervenient. Even nonderivative value (value that something has in its own right; value that is, in some way, not attributable to the value of anything else) is usually understood to be supervenient on certain nonevaluative features of the thing that has value (and thus to be attributable, in a different way, to these features). To repeat: whatever is intrinsically good is (barring the complication to be discussed in Section 5) nonderivatively good. It would be a mistake, however, to affirm the converse of this and say that whatever is nonderivatively good is intrinsically good. As intrinsic value is traditionally understood, it refers to a particular way of being nonderivatively good; there are other ways in which something might be nonderivatively good. For example, suppose that your interlocutor were to ask you whether it is good to eat and drink in moderation and to exercise regularly. Again, you would say, Yes, of course. If asked why, you would say that this is because such behavior promotes health. If asked

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Equity Valuation and Analysis what is good about being healthy, you might cite something else whose goodness would explain the value of health, or you might simply say, Being healthy just is a good way to be. If the latter were your response, you would be indicating that you took health to be nonderivatively good in some way. In what way, though? Well, perhaps you would be thinking of health as intrinsically good. But perhaps not. Suppose that what you meant was that being healthy just is good for the person who is healthy (in the sense that it is in each person's interest to be healthy), so that John's being healthy is good for John, Jane's being healthy is good for Jane, and so on. You would thereby be attributing a type of nonderivative interest-value to John's being healthy, and yet it would be perfectly consistent for you to deny that John's being healthy is intrinsically good. If John were a villain, you might well deny this. Indeed, you might want to insist that, in light of his villainy, his being healthy is intrinsically bad, even though you recognize that his being healthy is good for him. If you did say this, you would be indicating that you subscribe to the common view that intrinsic value is nonderivative value of some peculiarly moral sort. Let us now see whether this still rough account of intrinsic value can be made more precise. One of the first writers to concern himself with the question of what exactly is at issue when we ascribe intrinsic value to something was G. E. Moore [1873-1958]. In his book Principia Ethica, Moore asks whether the concept of intrinsic value (or, more particularly, the concept of intrinsic goodness, upon which he tended to focus) is analyzable. In raising this question, he has a particular type of analysis in mind, one which consists in breaking down a concept into simpler component concepts. (One example of an analysis of this sort is the analysis of the concept of being a vixen in terms

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Equity Valuation and Analysis of the concepts of being a fox and being female.) His own answer to the question is that the concept of intrinsic goodness is not amenable to such analysis. In place of analysis, Moore proposes a certain kind of thought-experiment in order both to come to understand the concept better and to reach a decision about what is intrinsically good. He advises us to consider what things are such that, if they existed by themselves in absolute isolation, we would judge their existence to be good; in this way, we will be better able to see what really accounts for the value that there is in our world. For example, if such a thought-experiment led you to conclude that all and only pleasure would be good in isolation, and all and only pain bad, you would be a hedonist. Moore himself deems it incredible that anyone, thinking clearly, would reach this conclusion. He says that it involves our saying that a world in which only pleasure existed a world without any knowledge, love, enjoyment of beauty, or moral qualities is better than a world that contained all these things but in which there existed slightly less pleasure. Such a view he finds absurd. Regardless of the merits of this isolation test, it remains unclear exactly why Moore finds the concept of intrinsic goodness to be unanalyzable. At one point he attacks the view that it can be analyzed wholly in terms of natural concepts the view, that is, that we can break down the concept of being intrinsically good into the simpler concepts of being A, being B, being C, where these component concepts are all purely descriptive rather than evaluative. (One candidate that Moore discusses is this: for something to be intrinsically good is for it to be something that we desire to desire.) He argues that any such analysis is to be rejected, since it will always be intelligible to ask whether (and, presumably, to deny that) it is good that something be A, B, C,, which would not be the

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Equity Valuation and Analysis case if the analysis were accurate. Even if this argument is successful (a complicated matter about which there is considerable disagreement), it of course does not establish the more general claim that the concept of intrinsic goodness is not analyzable at all, since it leaves open the possibility that this concept is analyzable in terms of other concepts, some or all of which are not natural but evaluative. Moore apparently thinks that his objection works just as well where one or more of the component concepts A, B, C,, is evaluative; but, again, many dispute the cogency of his argument. Indeed, several philosophers have proposed analyses of just this sort. For example, Roderick Chisholm [1916-1999] has argued that Moore's own isolation test in fact provides the basis for an analysis of the concept of intrinsic value. He formulates a view according to which (to put matters roughly) to say that a state of affairs is intrinsically good or bad is to say that it is possible that its goodness or badness constitutes all the goodness or badness that there is in the world. Eva Bodanszky and Earl Conee have attacked Chisholm's proposal, showing that it is, in its details, unacceptable. However, the general idea that an intrinsically valuable state is one that could somehow account for all the value in the world is suggestive and promising; if it could be adequately formulated, it would reveal an important feature of intrinsic value that would help us better understand the concept. We will return to this point in Section 5. Rather than pursue such a line of thought, Chisholm himself has responded in a different way to Bodanszky and Conee. He has shifted from what may be called an ontological version of Moore's isolation test the attempt to understand the intrinsic value of a state in terms of the value that there would be if it were the only valuable state in existence to an intentional version of that test the attempt to

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Equity Valuation and Analysis understand the intrinsic value of a state in terms of the kind of attitude it would be appropriate to have if one were to contemplate the valuable state as such, without reference to circumstances or consequences. This new analysis in fact reflects a general idea that has a rich history. Franz Brentano [1838-1917], C. D. Broad [1887-1971], W. D. Ross [1877-1971], and A. C. Ewing [1899-1973], among others, have claimed, in a more or less qualified way, that the concept of intrinsic goodness is analyzable in terms of the worthiness of some attitude. Such an analysis is supported by the mundane observation that, instead of good, we often use the term valuable, which itself just means: worthy of being valued. It would thus seem very natural to suppose that for something to be intrinsically good is simply for it to be worthy of being valued for its own sake. (Worthy here is usually understood to signify a particular kind of moral worthiness, in keeping with the idea that intrinsic value is a particular kind of moral value. The underlying point is that those who value for its own sake that which is intrinsically good thereby evince a kind of moral sensitivity.) Though undoubtedly attractive, this analysis can be and has been challenged. Brand Blanshard [1892-1987], for example, has claimed that, even if it is necessarily true that whatever is intrinsically good is worthy of being valued for its own sake, and vice versa, the proposed analysis of the concept of intrinsic goodness in these terms must be rejected because, if we ask why something is worthy of being valued for its own sake, the answer is that this is the case precisely because the thing in question is intrinsically good; this answer indicates that the concept of intrinsic goodness is more fundamental than that of the worthiness of being valued, which is inconsistent with analyzing the former in terms of the latter. Ewing and others have resisted this type of argument. Note that, even if the argument succeeds, it may

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Equity Valuation and Analysis nonetheless be necessarily true that whatever is intrinsically good is worthy of being valued for its own sake, and vice versa. If this were the case, it would reveal another important feature of intrinsic value, recognition of which would again help us to improve our understanding of this concept. One final cautionary note. It is apparent that some philosophers use the term intrinsic value and similar terms to express some concept other than the one just discussed. In particular, Immanuel Kant [1724-1804] is famous for saying that the only thing that is good without qualification is a good will, which is good not because of what it effects or accomplishes but in itself.This may seem to suggest that Kant ascribes (positive) intrinsic value only to a good will, declaring the value that anything else may possess merely extrinsic, in the senses of intrinsic value and extrinsic value discussed above. This suggestion is, if anything, reinforced when Kant immediately adds that a good will is to be esteemed beyond comparison as far higher than anything it could ever bring about, that it shine[s] like a jewel for its own sake, and that its usefulnesscan neither add to, nor subtract from, [its] value. For here Kant may seem not only to be invoking the distinction between intrinsic and extrinsic value but also to be in agreement with Brentano et al. regarding the characterization of the former in terms of the worthiness of some attitude, namely, esteem. (The term respect is often used in place of esteem in such contexts.) Nonetheless, it becomes clear on further inspection that Kant is in fact discussing a concept quite different from that with which this article is concerned. A little later on he says that all rational beings, even those that lack a good will, have absolute value; such beings are ends in themselves that have a dignity or intrinsic value that is above all price. Such talk indicates that Kant believes that the

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Equity Valuation and Analysis sort of value that rational beings possess is infinitely great. But then, if this were understood as a thesis about intrinsic value as we have been understanding this concept, the implication would seem to be that, since it contains persons, our world is as good as it could be. Yet this is something that Kant explicitly rejects elsewhere. It seems best to understand Kant, and other philosophers who have since written in the same vein, as being concerned not with the question of what intrinsic value rational beings have in the sense of intrinsic value discussed above but with the quite different question of how we ought to behave toward such creatures.

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Equity Valuation and Analysis

Market anomaly models

If the stock markets were totally efficient, then there would be no systematic gain from investing in stocks with certain easily identifiable characteristics such as low P/E, small capitalization and low analyst coverage. However, such market anomalies do infact

exist. Donald kim discusses five sources of anamolous return in the stock market: high dividend stocks, small capitalization stocks, low P/E stocks, abnormally high returns for the month of January, and abnormally high returns for stocks rated 1 in the value line timeless market.

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Equity Valuation and Analysis

Capital asset pricing model:

Those who use the CAPM model for active equity management style employ its prediction that in equilibrium, the expected stock return is an exact linear function of the risk free rate, the beta for the stock, and he expected return on the market portfolio. This linear equation is called the security market line. In theory, the stock whose expected return from the valuation model equates the expected return from the CAPM is to be in the equilibrium. If the expected return from the DDM were greater than the expected return from the CAPM, then the market would adjust the price of the stock upward and hence lower its expected return. If the expected return from the DDM were less than the expected return from the CAPM, then the market would adjust the price upward and hence lower its expected return. If the expected return of CAPM were less than the expected return from the DDM then the market would adjust the price of the stock downward and hence raise its expected return.

The CAPM has said a lot lesser so far as the prices are concerned. The discussion had revolved around risk and expected returns. Concentrating on risk and return was simply a convenient approach to the problem. Nonetheless, it is the security price, which is transacted in the markets and which determines speculative opportunities exist.

The equilibrium price should not provide any opportunities for speculative profits. It should be set at a level that expected returns from buying the security are identical to those available on an efficient portfolio of equivalent non-diversifiable risk. The

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Equity Valuation and Analysis equilibrium pricing formula strictly applies to the single period world. There is no warranty on its validity when it is used in other situations. In practice, however, the principal features of the model are used widely. Security analysts forecast expected future dividends and prices on a stock and discount them to the present using a discount rate generated from SML.

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Equity Valuation and Analysis

Strategies
The approaches explained are not mutually exclusive. Rather many of these models can be used in combination with each other in sound judgment. The quantitative strategy in valuation models may be defined as the engineered investment strategies. In developing these strategies, consideration must be given at least to three characteristics. First, strategy should be based on a sound theory. Thus, there should be not only the reason why the strategy worked in the past , but more importantly, a reason why should it be expected in the future. Second, the strategy should be put in quantified terms. Finally a determination should be made of how the strategy would have performed in the past. This last characteristic is critical and is the reason why investment strategies are back tested.

An equity manager encounters many potential problems in the design, testing, and implementation of engineered investment strategies. These include 1. Insufficient rationale: There is insufficient rationale for why a strategy

worked in the past and why it is estimated that it will work in the future. 2. Blind assumptions: Some strategies are based on the blind assumption that

certain factors are always good or bad. 3. Data mining: Data mining occurs when so many strategies are tested that,

by the laws of chance, on works. This is related to the problem of insufficient rationale and investment analyst uncovers statical relationships that are not expected

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Equity Valuation and Analysis to any investment theory or substantive model and may well be just a result of the type or data or statically model used or per se chance. 4. Quantity of data: In searching for investment strategies, managers use

computerized historical data. These databases often suffer from problems of inaccuracy, omissions, and survivor bias. Survivor bias occurs when the companies that disappeared are eliminated from the database. As a result any testing of potential strategy that includes only surviving companies would be biased in favor of survivors. 5. Look- ahead bias: This bias involves testing an investment strategy using

data that would not have been available at the time the strategy was formulated. For example the manager is testing a strategy involving price earnings ratio and performs the following test. If the P/E ratio is greater than the specified value on December 31 st then sell the stock on January 1st. If it is less than the specified value then buy the stock. The look ahead bias is that the P/E ratio is based on actual earnings for the year ending December 31st cannot be calculated on 31st December because actual earnings for the year ending 31st December are reported in the first quarter next year. Thus in conducting this back test the manager would be using data on 31 st December that were not available on that date.

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Equity Valuation and Analysis

Conclusion:
Comparative selection decisions for most industrial equity shares can usually be intelligently achieved through the appropriate use of one or more of the valuation techniques. The data on individual equity derived from these techniques should ordinarily be compared with the benchmark for a representative stock market average or index given an indication of the comparative values available in the market. In all cases, however a subjective interpretation of the various quality features is inherently a part of the decision process. However, it might be noted that even the most sophisticated appraisal techniques cannot assure superior long-term investment results. Because results entirely depend upon the realization of future earnings and dividend. Such possibilities are one reason for portfolio diversification f reasonable proportions. But at the same time it would seem only reasonable that selection decision derived from a penetrating analytical process of the quality of the company and its earnings an dividend potential in relation to the price of the stock should substantially increase the probabilities of obtaining satisfactory long term investment results.

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Equity Valuation and Analysis

Bibliography
1) Security analysis and portfolio management---- V K Bhalla 2) Security analysis and portfolio management---- Donald fischer 3) Various Internet sites 4) Modules of certified program in capital markets. (CPCM)

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