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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
sie 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
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historical and current information is not fully and correctly reflected in the
current price of the stock. !ence 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. "y 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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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. %fter identifying attractive and unattractive sectors and
industries, the top down manager finally selects the portfolio of individual
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The process is represented in the figure given below&
Economic forecast

%sset allocation

'ector analysis
% manager who uses bottom up equity approach de(emphasies the
significance of economic and market styles and focuses instead on the
analysis of individual securities. )sing 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 capitaliation, low analyst coverage etc$
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*inancial markets
'tock markets
+ther asset markets
Equity portfolio
Sub cateories o! active equity manaement
'ome of the ma,or sub categories of the two ma,or style of active equity
management are listed below&
"ro#t$ manaers: -rowth managers can be classified as either top(
down or bottom .up. The growth managers are either divided into
large capitaliation or small capitaliation. The growth managers buy
securities that are typically selling at relatively high /0E ratios, due to
high earnings growth rate, with the expectation of continued high
earnings growth. The portfolios are characteried by high /0E ratios,
high returns, and relatively low dividend yields.
%ar&et 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 equities. 1ather he0she
moves in and out of the market depending on the economic, technical
and analytical skills he0she dictates.
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Heders: The hedger seems to buy equities but also to place well(
defined limits on the investor2s investment limits. +ne 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.
'alue manaers: These are sometimes referred to as contrarians. This
is because they sometimes see value where many other market
participants don2t. 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. 3alue managers
use dividend discount.
"rou( rotation manaers: 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. !e can then select those sectors and
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economies that are going benefit. *or example if the economy were
perceived to be on the verge of moving from recession to recovery, the
group rotator would begin to purchase stocks in the appropriate
sectors and specific industries that are sensitive to the pick up in the
Tec$nicians: They discern market cycles and pick up securities solely
on the basis of historical price movements as they related to the
pro,ected price movements. "y reading a chart and artfully discerning
patterns, the technician hopes to be able to predict the future path of
the price action models /0E, earning surplus etc. In terms of
characteristics, value managers have relatively low betas, low price
book and /0E ratios and high dividend yields.
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Equity valuation models
The purpose of these models is to identify whether the stock is overpriced
or under priced. )nder priced stocks need to be purchased and over
priced stock need to be shorted4
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.

5et us consider an example. 'uppose we have an opportunity to receive 677
a year from now. 8ow if the interest rate is 69: then the present value shall
P'E * +uture value

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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.
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5et us assume there is an investor whose cost of capital is & and decides to
invest in a company. %s a first step he calculates the ad,usted earnings per
share over the past few years and examines the stability of earnings and their
growth and on the basis of these findings and of a company2s outlook
derives an estimate of the future earnings of the company. *or 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 investor4
-iven the data the value can be calculated as below&
' * E - E -4411 E
,1-&. ,1-&./2 ,1-&./t
Thus in this manner the expected stream of earnings, capitalied at the
investor2s cost of capital measures the intrinsic value of the share. 8ow we
compare this valuation with the current stock price #/$. 8ow if 3(/<7 then
the stock is under priced therefore the investor should purchase it and if it is
=7 then it is over priced and therefore the investor should sell it.
>ifferent investors can be expected to evaluate the investments differently.
'ome will decide to buy the equity while others will decide to sell the
equity if they already sell now. This differential behaviour reflects two
principal factors&
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a$ >ifferent individuals have different cost of capital so that calculation
using one discount rate may result in negative 8/3
while the use of other discount rate may be give a positive 8/3.
b$ Even if both investors have the same cost of capital, differences in their
estimates of the firm2s profitability may result in different investment
5ASIC %67E8: +ne of the most used equity valuation model is the
dividend discount model. In its simplest form, the >>? defines the intrinsic
value of a share as the present value of future dividend. These are several
variations of the >>? because of different assumptions about the growth
rate of dividend and its relationship to the discount rate used to calculate
present values.
9ER6 "R6:TH %67E8S: The most basic of all the >>' is the ero
growth model. This model assumes that the dividend will be constant over
time, so that growth is ero, and that the investor2s required rate of return is
C6;STA;T "R6:TH %67E8S: In this model cash dividends are
expected to grow at the constant rate. In order to find the discounted present
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value of the stream of constantly rising dividends, the investors can use the
equation of constant growth of dividends.
Intrinsic 'alue * 71
This equation tells us that the value of an equity share is equal to the cash
dividend in time period 6 discounted by the difference between the required
rates of return required by equity investors and growth rate of dividends. In
using this equation the value of dividend anticipated in the coming year is to
be taken.
*or example if an investor has a share whose current cash dividend at time 7
is @, the constant growth rate of dividend is6A: per year and the required
rate of return is 97:, the value of this share will be
Intrinsic 'alue * ),1-11>.
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8ote that the current price of 1s. B9 is much higher than the 1s.97 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.
'ARIA58E "R6:TH 6+ 7I'I7E;7: Consider a firm grows at a faster
rate for a few years and then reverts to a constant growth rate or no growth
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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&
'alue * 7o ,1-?./t

Where g
; 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&
Intrinsic 'alue * 7o,1-?.
- 7n-1 @ 1 A
,&=y. ,1-&./n
To illustrate the use of this multiple growth rate dividend valuation method,
consider the case of this hypothetical company DEF.
The company paid its first cash dividend of 1s.9.A today and dividends are
expected to grow at the rate of G7: for the next G years. Thereafter cash
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dividends are expected to grow at the rate of 67:. *urther the shareholders
are expecting 6A: rate of return.
*irst we shall calculate the present value of dividends for the first G years&
Eear >ividend
/resent value
#6$ #9$ #G$ #@$;#9$J#G$
7 9.A
6 G.9A .KL7 9.K9LA
9 @.99A .LAM G.6B@6
G A.@BG .MAK G.M6@7
')? ; 9.6356
'tep 9
3alue at the end of the G
year for the remaining life of the company will be&
73 ,1-?. * >1)33,1-110.*B10)23
Therefore value at the end of the third year
'3 * B10)23

* 12012)B
Therefore the present value is 697.@KMJ .MAK ;79.2797
Thus the value of the share is B.MGAM HLB.9LBL ; 88.9153
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'aluation models !or cyclical stoc&s:
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"auman 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. !e 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 find its growth rate
declining to the average shown in an industry. !ow long this
transition period lasts depends on the company, industry, product,
competition etcN % guide to follow is to determine the probable
position of the company in its life cycle.
*or example, if a company has been experiencing an abnormally high
growth rate, "auman suggests that, unless there is a sufficient evidence to
the contrary, the best earnings and dividend pro,ection is probably based on
a decreasing rate of growth, until it eventually approximates the secular
growth rate for the ma,ority of the companies in the company. *or 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.
%ccording to him in order to make a good estimate of future dividends, the
investor must ascertain
#a$ the current growth rate of dividend
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#b$ how long will it take until the growth rate has declined to the average
typical for the ma,ority of corporations.
+nce 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
rate4 "auman offers guidelines from M to 67 percent depending on the risk
The discount rate applied to the first year2s 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.
%lthough 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 ma,ority stock exchanges. "auman relies a lot on historical
data and believes this action is ,ustified by absence at present of any
indicators, which point to large changes ahead. !e reminds investors to be
on guard constantly to recognie signs of changes.
+bviously the cyclical model is difficult to formulate even on simple
configuration, but it does point out the variables that must be considered.
5et us assume that a stock has @ years business cycle from trough to peak to
trough, that the stock pays a regular dividend, and that the investor is willing
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to trade in and out of the stock but since the risks are great he must earn a
97: rate of return rather than a 67:
8ow if >6 is 6 and >9 is 6.K and /9 is K7, the present value of the stream of
income at 97: is
Intrinsic 'alue * 1 - 112
,1-112. ,1-112./2

* >C102
Therefore, if the stock is available at lower than AL.7K then it would provide
the speculative investor with a yield of over 97:. "ut 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. ?ay be his funds were placed in the savings bank.
' * 71 -72-C"2 -I3 -7) -7> - 7B-PB
,1-&. ,1-&./2 ,1-&./3 ,1-&./) ,1-&./> ,1-&./B
Where C-9 is the capital gain in year 9, IG and I@ are interest income and
>6, >9N 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 K: savings account then to repurchase at a low, and a final sale at a peak
in year M. 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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%odel based on (rice ratio analysis
i. Price equity ratio
The most popular ratio used to assess the value of the equity is the
company2s price equity ratio abbreviated as /0E ratio. It is calculated as the
ratio of the firm2s current stock price divided by the earnings per share
The inverse of the p0e 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 /0E ratios.
'ince 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.
?ost analysts prefer the first method of multiplying the latest quarterly
earnings per share value time four. !owever the difference is usually small,
but it can sometimes be source of confusion.
%nalysts often refer to high /0E stocks as growth stocks. To see why notice
that a /0E ratio is measured as a current stock price over current earnings
per share. 8ow consider two companies with the same current earnings per
share, where one company is a high growth company and the other is a low
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growth company. Which company should have a higher stock price, the
high growth company or the low growth company4
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 /0E ratio. In general companies with higher expected earnings will
have higher /0E ratio, which is why /0E stocks are referred to as the growth
The reason why they are referred to high growth stock is simple. The reason
is that low /0E 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. !owever it should be rated that
the term growth stock and value stock are most ,ustly commonly used
labels. +f course only time will tell whether a low /0E stock is of good
The /0E ratio used in the valuation equation is influenced by
i$ /0E 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 /0E ratios. The future level of the /0E ratio can
be viewed as the function of the current /0E ratios or the average /0E
ratio over the same period of time.
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ii$ The /0E ratio is a function of future expected earnings the higher the
growth rate of earnings the higher will be the /0E ratio. %n 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$ % normal /0E for the market is difficult to determine. % normal /0E
ratio is established for each company but it can be compared to the
market /0E to give some idea of risk. The higher the /0E ratio the
higher is the risk. This is true inspite of the fact that the investors are
ready to pay more.
iv$ Inflationary conditions tend to reduce the /0E ratios
v$ !igher interest rates tend to reduce the /0E ratios
vi$ /0E ratios vary by the industry
vii$ %n investor should examine the trend of the /0E ratio over time for
each company.
viii$ The level of /0E ratio is not an absolute one but a relative one.
ix$ 'peculative companies and cyclical companies tend to have a lower
x$ -rowth companies tend to have a higher /0E
xi$ Companies with larger portion of debt tend to have a lower /0E
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xii$ % company that tends to pay a higher dividend tend to have a higher
xiii$ /0E ratios can change radically and suddenly because of change the
expected growth rate of earnings. Therefore the greater the expected
stability of the growth rates the higher the /0E ratio.
!ow can the /0E ratio be used as guide in making an investment decision4
*or this the analyst is to apply various rules of thumb on company2s
earnings selecting an appropriate /0E 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. *or this the analyst mat ascertains
the median or the mean /0E for the equity as well as its range over the time.
?ore weight can be given to the recent past. This provides boundaries
within which the /0E must fall and indicates whether the equity is tending to
sell at the upper limits of expectation or the lower limits. Industry /0E
provide the guidelines, however the different companies in the same
industry frequently carry different /0Es. 1obert *erguson presents a method
of determining ,ustifiable price earnings ratio for growth stocks as
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compared to the standard. !is ob,ectives are to answer the following
%$ !ow many years of the present high growth rate are assumed by today2s
market price before the growth rate of the company drops to the standard
"$ What price earning ratio is ,ustified given a certain growth rate which is
higher than the standard rate for a certain number of years 4
*erguson takes the market price as a base and then determines what
estimates of the basic factors the market makes. !e then leaves the investors
to decide whether these estimates are too low or too high in his ,udgement.
*erguson 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.
/a ; #6H1a$In
/6a #6H1b$In
/a ; some standard price earning ratio
/6a ; growth stock price earning ratio
1a ; standard growth rate assumed
1b ; rate of growth assumed for growth stock
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%lthough it appears that *erguson 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 in price0 earnings
ratio arise only from the differences in assumed growth rates and duration.
% 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. %n analysis based on the foregoing assumption differs
ofcourse very strongly from "ausans 3ariable growth rate. That assumes
evenly declining growth rates and increasing discount rates for income with
longer futurity.
In the last paragraph *erguson states
PWe 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. %n approximate ad,ustment 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 rateQ
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This implicitly assumes that the current market price of stock completely
disregards dividend payments. ?oreover, this procedure would represent
double counting and overstate ,ustifiable price0earning ratios for the growth
stocks, since dividend payout is already implicitly in the standard
price0earnings ratio used in his equation.
;ic$olas %olodovs&y believes that any standardied selections of future
periods, such as 67 years for instanse, cold serve illustrative purpose only.
!e stressed that in actual practice, pro,ections of future earnings trends of
different stock would have to be made for whatever varying period might be
successfully indicated. The nature of the industry to which a company
belongs( as well as the corporations particular characteristics( should in
reality determine both the length of the period for which the earnings are
pro,ected into the future and also the delicate process of the Rsplicing2 with
an overall historical date. >epending on each individual case, such a
transition may well take the form of mathematical curves with very different
graduations of diminishing rates of growth. 'uch gradual transition can be
easily performed by a computer, which could also carry out the valuation
formula2s requirements of an infinite time horion. %ccording to him this
later condition can be easily met by combining the compound interest
formula used for complying a bond2s yield maturity with the expression of
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geometric progression for an infinite number of terms, which constitute a
mathematical description of an equities habitual market.
%ccording to him the appropriate rate will take into consideration the risks
involved, which are influenced by the growth of earnings or dividend
expected in the future, and the expected future price. In short, risk is a
function of the variability of return. % higher discount rate will be employed
whether the risk is greater and lower one when the risk is lower.
+ne commonly used approach is based on the multiple growth models and a
view that companies typically evolve through G stages during their lifetime.
These stages areO
11 "ro#t$ stae
The stage is characteried by rapidly expanding sales, higher profit margins
and abnormally high growth in the E/'. "ecause the expected profitability
of new investment opportunities is high, the payout ratio is generally low.
The unusually high earnings en,oyed in this stage attract competitors leading
to a gradual decline in the growth stage.
21 Transition stae
In the later years of the company2s life increased profit saturations begin to
reduce its growth rate, and its profit margins come under pressure. 'ince
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there are fewer investment opportunities the company begins to payout a
large percentage of earnings.
11 %aturity stae
-enerally, the company reaches a position where its new investment
opportunities offer, on average, slightly attractive returns on equity. %t that
time, its earning growth rate, payout ratio, and average return on equity
stabilie 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. +ne method involves
estimating values for the following variables
6. Expected earnings and dividend for the next five years
9. The growth rate of earnings and the payout ratio for the transition stages
which is assured to be in year six.
G. The duration of the transition stage((( that is the number of years until
the company reaches the maturity stage.
@. -rowth patters for the E/' and the payout ratio for the growth stage
A. 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.
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Seeremy C criticies methods of comparative valuation because they are
either base don price 0 earnings ratio or on price dividend ratios. !e argues
that, Pno one approach will give satisfactory results in a wide variety of
common stocksN because there are two investment reasons for owning
common stockN 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
6. >ebt H /reference as : of capital
9. >ebt H /reference as : of working capital
G. /ay out in : form
@. Total plow back as : of equity.
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Price cas$ !lo# ratio.
Instead of price earning ratio many analysts prefer to look at price cash flow
ratio. % price cash flow ratio is measured as the company2s 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 firm2s 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. +bviously this is logical.
!owever not all are actual cash expenses. The most important exception is
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. ?ost
analysts agree that in examining a company2s financial performance, cash
flow can be more informative than the net income.
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Price sales ratio
%n alternative view of company2s performance is provided by the price
sales ratio. % price sales ratio is calculated as the current price of the stocks
divided by the current annual sales revenue per share. % high /0' ratio
would suggest high sales growth, while a low would suggest sluggish sales
Price boo& ratio
% very basic price ratio for a company is the price book ratio, sometimes
called the market book ratio. % price book ratio is measures as the market
value of a company2s 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. % ratio bigger than 6 indicated that the firm has been successful in
creating value for its stockholders. % ratio less than 6 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. *or this and other reasons, price book ratios may not have much
information as they once did.
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%ll the above ratios discussed are commonly used to calculate the estimates
of expected future prices. ?ultiplying a historical average price ratio by an
expected future value for the price ratio denominator variable does this.
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'aluation equations !or !indin e?(ected 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 G several approaches are given
Random valuation model
The random valuation model begins with the premise that the next G years
growth of earnings dividend and price will be similar to those of 67 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 /0E ratio. "ut instead of assuming that the 67(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 67(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
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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 /0E ratio in the third year. The value for each variable
assumes to be around the historic mean plus one standard deviation of the
Intrinsic value
:$at Is Intrinsic 'alueD
The concept of intrinsic value has been characteried above in terms of the
value that something has Pin itself,Q or Pfor its own sake,Q or Pas such,Q or
Pin its own right.Q The custom has been not to distinguish between the
meanings of these terms, but we will see that there is reason to think that
there may in fact be more than one concept at issue here. *or the moment,
though, let us ignore this complication and focus on what it means to say
that something is valuable for its own sake as opposed to being valuable for
the sake of something else to which it is related in some way. /erhaps it is
easiest to grasp this distinction by way of illustration.
'uppose that someone were to ask you whether it is good to help others in
time of need. )nless you suspected some sort of trick, you would answer,
PEes, of course.Q If this person were to go on to ask you why acting in this
~ 32 ~
way is good, you might say that it is good to help others in time of need
simply because it is good that their needs be satisfied. If you were then
asked why it is good that peopleTs needs be satisfied, you might be puled.
Eou might be inclined to say, PIt ,ust is.Q +r you might accept the legitimacy
of the question and say that it is good that peopleTs needs be satisfied
because this brings them pleasure. "ut then, of course, your interlocutor
could ask once again, PWhatTs good about that4Q /erhaps at this point you
would answer, PIt ,ust is good that people be pleased,Q and thus put an end to
this line of questioning. +r perhaps you would again seek to explain the fact
that it is good that people be pleased in terms of something else that you take
to be good. %t some point, though, you would have to put an end to the
questions, not because you would have grown tired of them #though that is a
distinct possibility$, but because you would be forced to recognie 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 P,ust isQ 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
~ 33 ~
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
The account ,ust 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. *irst, 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$. %nother complication is that it may not in fact be accurate to
say that whatever is intrinsically good is nonderivatively good& some
intrinsic value may be derivative. This issue will be taken up #in 'ection A$
when the computation of intrinsic value is discussed& it may be safely
ignored for now. 'till another complication is this. It is almost universally
acknowledged among philosophers that all value is PsupervenientQ on
certain nonevaluative features of the thing that has value. 1oughly, what this
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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. *or 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.
'uppose 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 'ection A$ taking the value of the experiences to be
nonderivative. 8onetheless, 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
To repeatO whatever is intrinsically good is #barring the complication to be
discussed in 'ection A$ nonderivatively good. It would be a mistake,
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however, to affirm the converse of this and say that whatever is
nonderivatively good is intrinsically good. %s Pintrinsic valueQ is
traditionally understood, it refers to a particular way of being no
derivatively good& there are other ways in which something might be
nonderivatively good. *or example, suppose that your interlocutor were to
ask you whether it is good to eat and drink in moderation and to exercise
regularly. %gain, you would say, PEes, of course.Q If asked why, you would
say that this is because such behavior promotes health. If asked what is good
about being healthy, you might cite something else whose goodness would
explain the value of health, or you might simply say, P"eing healthy ,ust is a
good way to be.Q If the latter were your response, you would be indicating
that you took health to be nonderivatively good in some way. In what way,
though4 Well, perhaps you would be thinking of health as intrinsically good.
"ut perhaps not. 'uppose that what you meant was that being healthy ,ust is
Pgood forQ the person who is healthy #in the sense that it is in each personTs
interest to be healthy$, so that SohnTs being healthy is good for Sohn, SaneTs
being healthy is good for Sane, and so on. Eou would thereby be attributing a
type of nonderivative interest(value to SohnTs being healthy, and yet it would
be perfectly consistent for you to deny that SohnTs being healthy is
intrinsically good. If Sohn were a villain, you might well deny this. Indeed,
~ 36 ~
you might want to insist that, in light of his villainy, his being healthy is
intrinsically bad, even though you recognie that his being healthy is good
for him. If you did say this, you would be indicating that you subscribe to
the common view that intrinsic value is nonderivative value of some
peculiarly moral sort.
5et us now see whether this still rough account of intrinsic value can be
made more precise. +ne of the first writers to concern himself with the
question of what exactly is at issue when we ascribe intrinsic value to
something was -. E. ?oore U6KLG(6BAKV. In his book Principia Ethica,
?oore asks whether the concept of intrinsic value #or, more particularly, the
concept of intrinsic goodness, upon which he tended to focus$ is analyable.
In raising this question, he has a particular type of analysis in mind, one
which consists in Pbreaking downQ a concept into simpler component
concepts. #+ne example of an analysis of this sort is the analysis of the
concept of being a vixen in terms of the concepts of being a fox and being
female.$ !is own answer to the question is that the concept of intrinsic
goodness is not amenable to such analysis. In place of analysis, ?oore
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. !e advises us to consider what things are such that, if
~ 37 ~
they existed by themselves Pin absolute isolation,Q we would ,udge 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. *or 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. ?oore
himself deems it incredible that anyone, thinking clearly, would reach this
conclusion. !e says that it involves our saying that a world in which only
pleasure existed W a world without any knowledge, love, en,oyment of
beauty, or moral qualities W is better than a world that contained all these
things but in which there existed slightly less pleasure. 'uch a view he finds
1egardless of the merits of this isolation test, it remains unclear exactly why
?oore finds the concept of intrinsic goodness to be unanalyable. %t one
point he attacks the view that it can be analyed wholly in terms of PnaturalQ
concepts W 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 CN,
where these component concepts are all purely descriptive rather than
evaluative. #+ne candidate that ?oore discusses is thisO for something to be
intrinsically good is for it to be something that we desire to desire.$ !e
argues that any such analysis is to be re,ected, since it will always be
~ 38 ~
intelligible to ask whether #and, presumably, to deny that$ it is good that
something be A, B, C,N, which would not be the case if the analysis were

Even if this argument is successful #a complicated matter about
which there is considerable disagreement$, it of course does not establish the
more general claim that the concept of intrinsic goodness is not analyable at
all, since it leaves open the possibility that this concept is analyable in
terms of other concepts, some or all of which are not PnaturalQ but
evaluative. ?oore apparently thinks that his ob,ection works ,ust as well
where one or more of the component concepts A, B, C,N, is evaluative& but,
again, many dispute the cogency of his argument. Indeed, several
philosophers have proposed analyses of ,ust this sort. *or example, 1oderick
Chisholm U6B6M(6BBBV has argued that ?ooreTs own isolation test in fact
provides the basis for an analysis of the concept of intrinsic value. !e
formulates a view according to which #to put matters roughly$ 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 "odansky and Earl Conee have attacked ChisholmTs proposal, showing
that it is, in its details, unacceptable. !owever, the general idea that an
intrinsically valuable state is one that could somehow account for all the
~ 39 ~
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 'ection
A. 1ather than pursue such a line of thought, Chisholm himself has
responded in a different way to "odansky and Conee. !e has shifted from
what may be called an ontological version of ?ooreTs isolation test W 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 W to an
intentional version of that test W the attempt to 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. *ran "rentano U6KGK(6B6LV, C. >.
"road U6KKL(6BL6V, W. >. 1oss U6KLL(6BL6V, and %. C. Ewing U6KBB(6BLGV,
among others, have claimed, in a more or less qualified way, that the concept
of intrinsic goodness is analyable in terms of the worthiness of some
attitude. 'uch an analysis is supported by the mundane observation that,
instead of Pgood,Q we often use the term Pvaluable,Q which itself ,ust meansO
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
~ 40 ~
valued for its own sake. #PWorthyQ 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. "rand "lanshard U6KB9(6BKLV, 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 re,ected
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 analying the former in terms of the latter.
Ewing and others have resisted this type of argument. 8ote that, even if the
argument succeeds, it may 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.
~ 41 ~
+ne final cautionary note. It is apparent that some philosophers use the term
Pintrinsic valueQ and similar terms to express some concept other than the
one ,ust discussed. In particular, Immanuel Xant U6L9@(6K7@V is famous for
saying that the only thing that is Pgood without qualificationQ is a good will,
which is good not because of what it effects or accomplishes but Pin
itself.QThis may seem to suggest that Xant ascribes #positive$ intrinsic value
only to a good will, declaring the value that anything else may possess
merely extrinsic, in the senses of Pintrinsic valueQ and Pextrinsic valueQ
discussed above. This suggestion is, if anything, reinforced when Xant
immediately adds that a good will Pis to be esteemed beyond comparison as
far higher than anything it could ever bring about,Q that it PshineUsV like a
,ewel for its own sake,Q and that its PusefulnessNcan neither add to, nor
subtract from, UitsV value.Q *or here Xant may seem not only to be invoking
the distinction between intrinsic and extrinsic value but also to be in
agreement with "rentano et al. regarding the characteriation of the former
in terms of the worthiness of some attitude, namely, esteem. #The term
PrespectQ is often used in place of PesteemQ in such contexts.$ 8onetheless,
it becomes clear on further inspection that Xant is in fact discussing a
concept quite different from that with which this article is concerned. % little
later on he says that all rational beings, even those that lack a good will,
~ 42 ~
have Pabsolute valueQ& such beings are Pends in themselvesQ that have a
PdignityQ or Pintrinsic valueQ that is Pabove all price.Q 'uch talk indicates
that Xant believes that the sort of value that rational beings possess is
infinitely great. "ut 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.
Eet this is something that Xant explicitly re,ects elsewhere. It seems best to
understand Xant, 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 W in the sense of Pintrinsic valueQ discussed above W
but with the quite different question of how we ought to behave toward such
%ar&et 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 /0E, small capitaliation and low analyst coverage. !owever,
such market anomalies do infact exist. >onald Xim discusses five sources of
anomalous return in the stock marketO high dividend stocks, small
capitaliation stocks, low /0E stocks, abnormally high returns for the month
~ 43 ~
of Sanuary, and abnormally high returns for stocks rated P6Q in the value line
timeless market.
Ca(ital Asset Pricin %odel
Those who use the C%/? 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 C%/? is to be in the
equilibrium. If the expected return from the >>? were greater than the
expected return from the C%/?, then the market would ad,ust the price of
the stock upward and hence lower its expected return. If the expected return
from the >>? were less than the expected return from the C%/?, then the
market would ad,ust the price upward and hence lower its expected return. If
the expected return of C%/? were less than the expected return from the
>>? then the market would ad,ust the price of the stock downward and
hence raise its expected return.
The C%/? has said a lot lesser so far as the prices are concerned. The
discussion had revolved around risk and expected returns. Concentrating on
~ 44 ~
risk and return was simply a convenient approach to the problem.
8onetheless, 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 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. 'ecurity analysts forecast expected future dividends and prices
on a stock and discount them to the present using a discount rate generated
from '?5.
~ 45 ~
The approaches explained are not mutually exclusive. 1ather many of these
models can be used in combination with each other in sound ,udgment. 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.
*irst, 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.
'econd, the strategy should be put in quantified terms.
*inally 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.
%n equity manager encounters many potential problems in the design,
testing, and implementation of engineered investment strategies. These
6. Insufficient rationaleO There is insufficient rationale for why a
strategy worked in the past and why it is estimated that it will work in the
~ 46 ~
9. "lind assumptionsO 'ome strategies are based on the blind
assumption that certain factors are always good or bad.
G. >ata miningO >ata 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 to any investment theory or
substantive model and may well be ,ust a result of the type or data or
statically model used or per se chance.
@. Yuantity of dataO In searching for investment strategies,
manager2s use computeried historical data. These databases often suffer
from problems of inaccuracy, omissions, and survivor bias. 'urvivor bias
occurs when the companies that disappeared are eliminated from the
database. %s a result any testing of potential strategy that includes only
surviving companies would be biased in favor of survivors.
A. 5ook( ahead biasO This bias involves testing an investment
strategy using data that would not have been available at the time the
strategy was formulated. *or example the manager is testing a strategy
involving price earnings ratio and performs the following test. If the /0E
ratio is greater than the specified value on >ecember G6
then sell the
stock on Sanuary 6
. If it is less than the specified value then buy the
~ 47 ~
stock. The look ahead bias is that the /0E ratio is based on actual earnings
for the year ending >ecember G6
cannot be calculated on G6
because actual earnings for the year ending G6
>ecember are reported in
the first quarter next year. Thus in conducting this back test the manager
would be using data on G6
>ecember that were not available on that
~ 48 ~
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
sub,ective interpretation of the various quality features is inherently a part of
the decision process.
!owever, it might be noted that even the most sophisticated appraisal
techniques cannot assure superior long(term investment results. "ecause
results entirely depend upon the realiation of future earnings and dividend.
'uch possibilities are one reason for portfolio diversification f reasonable
proportions. "ut 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.
~ 49 ~
1. Security analysis and (ort!olio manaement==== ' < 5$alla
2. Security analysis and (ort!olio manaement==== 7onald +isc$er
3. %odules o! certi!ied (roram in ca(ital mar&ets1 ,CPC%.
~ 50 ~