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FIN324 Review

FIN324 Review

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Security Analysis

Review
David Myers FIN 324
© David Hobson Myers, 2010

Myths of Valuation
Myth 1
Since valuation models are quantitative, valuation is objective

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

Myth 3
A good valuation provides a precise estimate of value
© David Hobson Myers, 2010

Myths of Valuation
Myth 4
The more quantitative a model, the better the valuation

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

Myth 6
The product of valuation is what matters; the process of valuation is not important.
© David Hobson Myers, 2010

2010 DCF CFt V =∑ t t =1 (1 + r ) V firm = ∑ t =1 n n Vequity = ∑ t =1 n CFequityt (1 + k e )t CFfirm t (1 + WACC )t © David Hobson Myers.Three Approaches to Valuation Discounted Cash Flow Relative Valuation Contingent Claims © David Hobson Myers. 2010 WACC = Cost of equity [Equity/(Debt+Equity)] + Cost of Debt [Debt/(Debt + Equity)] CAPM CAPM needs three inputs Riskless asset Risk premium Beta E ( R i ) = R f + E (R m ) − R f β i © David Hobson Myers. 2010 [ ] .

2010 . geometric averages • Arithmetic is BUE © David Hobson Myers. 2010 Equity Risk Premium • CAPM. no default risk • Governments print the money • Nominal terms – 2. APM. No reinvestment risk • Actual return = Expected return • Zero coupon bonds – Purist’s view • Different rates for each period – Duration matching strategy © David Hobson Myers. 2010 Fisher Approximation • Nominal Returns = Real Returns + Inflation • Observed Risk-Free Rates include expectations of real returns and future inflation © David Hobson Myers.Riskless Rates & Risk Premiums • Risk free rate – 1. Multifactor models E (R ) = R f + ∑ β j (Riskpremiu m ) j j =1 j =k • Historical Risk Premiums – Time period – Risk-free rate (consistent with E(R)) – Arithmetic vs.

us ) = R f + β j (USRP) + λ j (CRP ) © David Hobson Myers.Emerging Markets Risk Premiums 1. average beta Step 3: Unlevered comparable betas Step 4: Unlevered beta using value weighted average of comparables • Step 5: Levered beta © David Hobson Myers. 2010 . Preferred (country & market separate) E (R j . discretionary products – Degree of operating leverage • Cost structure – Fixed /total costs – Degree of operating leverage = % change in operating profit/% change in sales – Financial leverage βL = βU 1+ (1−τ ) D E [ ( )] © David Hobson Myers. 2010 Fundamental Beta • Beta of a firm determined by 3 variables – Type of business • Cyclical. 2010 Bottom up Betas • • • • Step 1: What business/industry Step 2: Comparable firms. Proportional exposure to country risk E (Rus ) = R f + β j (USRP + CRP ) 3. Equal exposure to country risk E (Rus ) = R f + β j (USRP ) + CRP  1 + ibrazil E (R Brazil ) = (1 + E ( Rus ))  1+ i  us     2.

ROC – Increased debt • How the transition is made from high (abnormal) to stable growth © David Hobson Myers.Terminal Values • Estimating Terminal Value T P0 = ∑ t =1 Ct PT + t (1 + rt ) (1 + rt ) t PT = CT +1 r−g – PT is the terminal value • perpetuity or liquidation value or multiples © David Hobson Myers. g < r • Growth approaches risk-free rate © David Hobson Myers. 2010 Key Assumptions • When the firm enters stable growth – Length of Competitive Advantage Period • What the firm characteristics are in stable growth – Beta approaches 1 – Industry averages ROE. 2010 Stable Growth • Valuation most sensitive to gS • Firm growth cannot be greater than economies in which in functions • Growth < Discount rate. 2010 .

. Capital = Free Cash flow to Equity (FCFE) [δ = Debt Ratio] & A Discount Rate Cost of Equity • Basis: The riskier the investment.Change in Work.In same currency and in same terms (real or nominal as cash flows + Beta ..Deprec’n) . . Terminal Value= FCFE FCFE n n+1 /(k Forever Discount at Cost of Equity Cost of Equity Riskfree Rate : .Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium © David Hobson Myers.No reinvestment risk .. n n+1 Forever Discount at Cost of Equity Cost of Equity Riskfree Rate : ..D: Mkt Val of Equity and Debt EBIT (1..EQUITY VALUATION WITH DIVIDENDS Dividends Net Income * Payout Ratio = Dividends Expected Growth Retention Ratio * Return on Equity Firm is in stable growth: Grows at constant rate forever Terminal Value= Dividend Value of Equity Dividend 1 Dividend 2 Dividend 3 Dividend 4 Dividend 5 Dividend ..tax rate) .(1.(Cap Ex .δ) (Capital Exp.δ) Change in Work.. the greater is the cost of equity.Deprec’n) ...No reinvestment risk .Change in WC (!-DR) = FCFE Expected Growth Retention Ratio * Return on Equity Firm is in stable growth: Grows at constant rate forever Value of Equity FCFE 1 FCFE 2 FCFE 3 FCFE 4 FCFE 5 ... • Models: CAPM: Riskfree Rate + Beta (Risk Premium) APM: Riskfree Rate + Σ Betaj (Risk Premiumj): n factors Cost of Capital WACC = ke ( E/ (D+E)) + kd ( D/(D+E)) k d = Current Borrowing Rate (1-t) E.Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium © David Hobson Myers.In same currency and in same terms (real or nominal as cash flows + Beta .Depr) (1..(Capital Exp. Capital = Free Cash flow to Firm (FCFF) Cashflows to Equity Cashflows to Firm .No default risk .Measures market risk X Risk Premium ... 2010 The Building Blocks of Valuation Choose a Cash Flow Dividends Expected Dividends to Stockholders Net Income .No default risk . 2010 Financing Weights Debt Ratio = DR EQUITY VALUATION WITH FCFE Cashflow to Equity Net Income .DR) ..(1.Measures market risk X Risk Premium .. .

The Essence of relative valuation? • Compare to the values assessed by the market for similar or comparable assets. Multiples are just standardized estimates of price… • Standardize – Earnings of the asset • Price/Earnings Ratio (PE) and variants (PEG and Relative PE) • Value/EBIT • Value/EBITDA • Value/Cash Flow – Book value of the asset • Price/Book Value(of Equity) (PBV) • Value/ Book Value of Assets • Value/Replacement Cost (Tobin’s Q) – Revenues generated by the asset • Price/Sales per Share (PS) • Value/Sales – Asset or Industry Specific Variable (Price/kwh. – Almost 85% of equity research reports are based upon a multiple and comparables. – controlling for any differences and then judge whether the asset is under or over valued Relative valuation is pervasive… • Most valuations on Wall Street are relative valuations...) . Price per ton of steel . – More than 50% of all acquisition valuations are based upon multiples – Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments.. – identify comparable assets and obtain market values for these assets – standardized values. since the absolute prices cannot be compared – compare the standardized value or multiple to comparable asset.

High Growth Multiple Used PE. VS VEBITDA REIT P/CF Financial Services Retailing PBV PS VS Black-Scholes Formula • Value a European call option on a nondividend paying stock • The Black-Scholes pricing formula is C0 = S 0 N (d1 ) − Xe − rT N (d 2 ) d1 = ln (S 0 X ) + r + σ 2 2 T σ T © David Hobson Myers. 2010 . 2010 ( ) d 2 = d1 − σ T Factors Affecting Option Prices Increase in Variable Stock Price E xercise Price T im e to m atu rity Stock volatility Interest rates C ash dividends Call + + + + Put + + + + © David Hobson Myers. Relative PE PEG Rationale Often with normalized earnings Big differences in growth across firms Assume future margins will be good Firms in sector have losses in early years and earnings can vary depending on depreciation method Generally no cap ex investments from equity earnings Book value often marked to market If leverage is similar across firms If leverage is different High Growth/No Earnings Heavy Infrastructure PS.Conventional Usage: A Summary Sector Cyclical Manufacturing High Tech.

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