Globalization reduces discount rate (Kc) investors require and companies pay to raise equity + solves information asymmetry
and agency Bank Valuation: analyzed accuracy multiples to valuing certain financial institutions, confuting PTBV better than PBV.
cost, by affecting the corporate governance system -> lifting restrictions to free transnational flows and removing frictions within mkts ->
easing and making cheaper equity raising
Countries open up capital markets to foreign investors -> benefit wider diversification reduces the risk of both foreign and domestic
investors’ portfolios substantially, without reducing their expected return. Hence, risk premiums and the cost of capital both for previously
segmented markets and already integrated markets drop; for this reason, in measuring the risk of individual firms and projects, the global
CAPM should be used. Here Beta is computed wrt global portfolio (not the local one) -> reduces Beta -> lower exposure to global markets.
As a consequence, the value of all firms whose cost of capital is determined in global markets increases.
Secondly, globalization would reduce the costs of external finance by improving the corporate governance system, in particular by enhancing
six mechanism of management monitoring, which reduces information asymmetry and agency cost: BoD (its presence is to protect minorities
-> raise cheap capital), capital markets (valuable firms from less developed markets supported by IB thanks to globalization -> globalization
as mechanism of signaling), legal system (mechanism of control and enforcement to mgmt -> firms subject to laws where they raise capital),
active shareholders (shareholders monitoring mgmt and thanks to globalization foreign shareholders act as a guarantee for minorities),
market for corporate control (its existence is a disciplinary effect on mgmt, even where takeovers not allowed thanks to competition with
foreigners) and disclosure (condition to raise funds in capital markets: if listing in regulated mkts, interpreted positively).
Globalization reduces bid-ask spread (this one influenced expected return before transaction) because 1) more investors; 2) reduction risk
insider trading increase #investors and mkt makers -> increase liquidity and lower spread; 3) more competitions mkt makers vs IB; 4) listing
makes trading efficient and cheaper. NB: liquidity good for mgmt monitoring thanks to more info incorporated in prices.
- If firm not seek funds in global mkts -> signal poor performance
- If firm large shareholders -> influence mgmt -> small investor pay less for a stake (higher required return)
EMPIRICAL PART: Global CAPM for open mkts: ERP equivalent ERP world mkt portfolio*B(local vs global portfolios)
- Volatility stock prices components global portfolio -> impact on risk premium other components
- !!!NB!!! Opening up not linear development: also step backwards -> Ke depends on Local CAPM when doing so (GLOBAL when
steps towards integration)
- Small firms/ high Book-to-Mkt -> higher than expected valuations when using Global CAPM (not a issue of it)
TIME SERIES EVIDENCE: using the time-series averaging method to evaluate ERP (past forecasts future and need many past data) for
estimating the cost of capital does not capture the effect of globalization, given the lack of stability in the risk premium due to joining of
many countries and more risk being diversified -> Kc should be reduced
EVENT STUDY APPROACH: evaluate equity capitalization firms and country pre and after liberalization events -> Delta Wealth = +30%.
Keeping constant CFs, Kc has declined. NB: actually also CF grow and could be good stock mkt performance -> liberalization, not contrary ->
we could being overstating globalization effects.
ADRs listing: if firms being valued at GLOBAL cost of capital (during ADR listing) -> rise in value -> TRUE but SMALL: P rise when listing
announced and when listed. NB: if company from isolated country, rise is bigger.
Another result: US firms raising D abroad -> Value increase vs domestic debt raising
DECREASE in Kc LESS THAN EXPECTED: because 1) efficient financial markets would anticipate the globalization to some degree; 2)
globalization is not instantaneous <-> investors not as well-diversified internationally as the theory suggest they should be (home bias: why?
Restrictions, info asymmetry, political risks).
- If liberalization but no investors take advantage of it/ firms list abroad but no foreign investor-> Kc not decrease
SUMMARY: A) Cap mkts merging in a global one -> higher stock prices. Wider investor basis -> Kc lower -> higher Ve
B) ERP not stable in time due to globalization -> not stable -> past not forecast future
C) in measuring risk should use global CAPM, especially if projects/ financing abroad thanks to diversification
Probabilistic Approaches: rather than compute an expected value that tries to capture all of the different possible outcomes, the approaches
provided give information on what the value of the asset will be under each outcome, or at least a subset of them.
SCENARIO ANALYSIS: estimate expected CFs & asset values under various scenarios (best case / worst case / multiple ->
not complete assessment of all scenarios -> sum prob may be <1). Need to determine factors, #scenarios, estimation CFs in each scenario
and probability each one. Range values got across different scenarios provides snapshot riskiness asset (the wider the range of values, the
riskier). Also, useful to determine inputs that most affect the value. Best suited for concurrent and discrete risk. The drawbacks are the trade-
off between the higher number of scenarios and the accuracy of the estimation of cash flows under each one of themn (Garb in Garb Out),
the difficulty in use for continuous outcomes, the double counting of risk, difficulty to show objective choice for correlation -> subjective.
DECISION TREES: divide analysis into risk phases, establish probability for each outcome in each phase, define decision
points, compute value at end nodes and folding back the tree (expected values computed working backward). Best suited for discrete
(convert continuous risk in manageable set outcomes) and sequential risk. The present expected value will incorporate the potential up-
downside from risk and actions would be taken. Also, range of values at the end nodes embeds the potential risk in the investment. The
benefits in using this approach are the dynamic response to risk, value of information in decision making, risk management (picture of how
cash flows unfold over time). However, since it is built for modeling sequential risks, concurrent risks cannot be taken into account.
SIMULATIONS: determine probabilistic variables, focusing attention on variables that have significant impact on value and
that are not too much correlated (correlation can me modeled though). Then, probability distribution for each variable has to be found and
finally a simulation is ready to be run. Well suited for modeling continuous risk (all possible outcomes). Also, since a deeper analysis has to
be done in order to run a simulation, a better input estimation is the first advantage. Then, the result of a simulation is a distribution for
expected value, rather than a point estimate, leading to better decisions. Simulation may be run with constraints, making simulations a tool
for risk analysis (BV/E not <0 -> identify way of hedging against adverse events). The issues analysts may encounter are the poor fit of real
data on statistical distributions, the non-stationarity of distributions over time and the correlation across inputs may change over time as
well.
All three approaches use expected cash flows rather than risk-adjusted cash flows, and the discount rate that is used should
be a risk-adjusted discount rate. Still preserve flexibility to change the risk adjusted discount rate for different outcomes.
NB: Quality info: simulations heavily dependent upon being able to assess probability distributions and parameters, work best when
substantial historical/ cross sectional data. With decision trees, need estimates probabilities of the outcomes each chance node: OK if risks
can be assessed either using past data or population characteristics. => when confronted with new and unpredictable risks, analysts use
scenario analysis, notwithstanding its slapdash and subjective ways of dealing with risk.
Risk adjusted values: Both decision trees and simulations can be used as either complements to or substitutes for risk-adjusted value.
Scenario analysis, on the other hand, will always be a complement to risk adjusted value, since it does not look at the full spectrum of possible
outcomes. All of these approaches use expected rather than risk adjusted cash flows and the discount rate that is used should be a risk-
adjusted discount rate; the risk-free rate cannot be used to discount expected cash flows. In all three approaches, though, we still preserve
the flexibility to change the risk adjusted discount rate for different outcomes. Since all of these approaches will also provide a range for
estimated value and a measure of variability (in terms of value at the end nodes in a decision tree or as a standard deviation in value in a
simulation), it is important that we do not double count for risk. In other words, it is unfair to discount risky cash flows back at a risk adjusted
rate (in simulations and decision trees) and to then reject them because the variability in value is high.
Both simulations and decision trees can be used as alternatives to risk adjusted valuation: the cash flows will be discounted at a risk-free
rate to arrive at value and the measure of variability in values in both approaches (range in decision trees and stdev in simulations) will be
our measure of risk in the investment. Comparing two assets with the same expected value (obtained with riskless rates as discount rates)
from a simulation, we will pick the one with the lower variability in simulated values as the better investment. If we do this, we are assuming
that all of the risks that we have built into the simulation are relevant for the investment decision. In effect, we are ignoring the line drawn
between risks that could have been diversified away in a portfolio and asset-specific risk.
Private Benefits of Control: An International Comparison
The objective of the authors is to understand the drivers and the effects on financial market
development of private benefits of control, why are they so different across countries and what
mechanisms and institutions could limit their effect. The analysis starts from 393 observations of
controlling block sales, of which the PBC are calculated as price per share paid by the acquirer –
price quoted in market the day after announcement. In order to identify the right transactions,
they looked for those which involved a transfer of a block of shares that conveyed control rights,
an observation of both the PPS for the control block and PPS post-announcement, and finally the
latter not restricted by regulation. To define the variables used in the analysis (i.e., role of law,
competition, violent crimes, labour power, tax compliance and all the others), many methods
were used: among the many, we have regressions, surveys, use of dummy variables, indices and
so on.
A few problems were encountered in the analysis: transactions which included related parties,
options, reported prices were screened out; defining some variable via a regression the
assumption made was that the contribution of each variable to PBCs is constant across countries;
medians were used sometimes (not always) in cases where outliers could bias the results.
In terms of results the sample of transactions used show an average of 14% of equity value as
control premium (Japan -4%; Brazil +65%). It is shown how, in countries with high PBC ownership
is more concentrated, capital markets are less developed and government privatizations rarely
take place in the forms of public offerings, which all show the importance of protecting
international investors in such environment. On the other hand, lower level of PBC seem to be
associated with factors such as better accounting standards, legal protection of minority
shareholders, better law enforcement, more intense product market competition, a high level of
diffusion of the press, and a high rate of tax compliance. A striking result, however, has been the
correlation between public opinion and media pressure on managers and lower levels of PBC.
Careful! As authors point out, not always managers bending to public pressure means value for
shareholders, and PBCs are not necessarily bad for financial system.
From 1990 to 2018, banks Europe and US. Two samples divided, subgroups wrt business model (Commercial vs
Investment Banks) and size (Small and Large). Multiples: P/E FY1, P/E FY2, Basic P/E with and without extraordinary
items, Diluted P/E with and without extraordinary items, P/BV, P/TBV (more conservative figure), P/Revenues,
P/Common Dividends (preferred as Pref div are stable and not connected to performace), P/Total Dividends,
P/Deposits (used in the past).
Relative valuation on the basis of out-of-sample multiples: excluding institution being valued from group of peers.
Harmonic mean used to compute theoretical price with less influence outliers and right asymmetry. Performance
multiples: (theo price - mkt price)/mkt price. The lower the valuation error (i.e., the difference between theoretical
and market price), the higher the performance of the multiple (assuming mkt prices efficient).
Use of multiples much more precise for American banks than for European ones, as wide heterogeneity among
European peers (strong differences in Eurozone as culture, financial education, regulation and stock markets)
- Forward P/Es best multiples: expected result as since prices should reflect future expectations. In fact
analysts’ earnings forecasts (vs reported earnings) -> direct estimate of future profitability and, since reflect
a larger info set -> more accurate. Moreover, forecasts exclude impacts of extraordinary events ->
sustainable proxy for permanent core earnings persisting in the future. P/E FY2 more precise than P/E FY1.
- Among practitioners, common practice to prefer P/TBV to P/BV, since the TBV (more liquid representation
of BV) considered less biased + more accurate for the banking sector. Interestingly, result analysis is opposite
with P/BV showing smaller errors than P/TBV. Errors particularly high during crises -> driven by a large #
outliers (e..g banks consistently trading below BV in Cyprus, Greece, Italy and Spain)
- P/Common Div preferred in Europe. In US differences less evident. Moreover, analysis multiples’
performances through time shows P/Common Dividends always follows an individual path, delivering poor
accuracy but being enough stable. It suggests dividends not best fundamental to use and that they can
potentially be misleading.
- P/deposits P/revenues not accurate, in particular in Europe <- high asymmetry. Good for American Large
CB. Nevertheless, consistently overperformed by other multiples. NB. Deposits less and less important;
revenues misleading as should be compared with asset-side measures + level risk underlying activities
generating these revenues not considered.
Euro introduction: multiple’s accuracy benefited from implementation common currency: 1) increased homogeneity
among comparable bank; 2) banks operating in different countries; 3) low currency risk; 4) increased stability thanks
to unique monetary policy.
2008 Financial Crisis: EU CB/IB: strong decrease in P/E FY accuracy (yet still best performers), PBV, PTBV good
performance (attention to capitalization during crisis). American CB/IB worsen the multiple’s performance, showing
how dependent they were to the sub-prime market in the US.
How Do Underwriters Select Peers When Valuing IPOs?
The objective of the authors is to understand whether the peer groups used by IB’s when
valuing firms going public are unbiased or manipulated somehow. They also try to demonstrate
a negative relationship between the potential bias size and the long run performance of the
stock. The paper poses itself against the efficient market hypothesis, willing to demonstrate
how investors fail to realize that they are being repeatedly tricked by the underwriters.
The analysis is focused on a sample of 361 IPOs in the European market from 1999 to 2012 and
compares the peers selected for the valuation with 5 alternative groups derived from: I.
Thomas One Banker Database; II. Propensity score-matching model (based on industry,
country, size, profitability); III. EV/Sales matching; IV. The first post-IPO equity report by buy
side analysts; V. first post-IPO equity report by sell-side analysts. Two variables are then
computed, “Valuation Bias”: an average (for each multiple) of the ratio between the multiple
used in the valuation and each of those based on alternative groups of peers and “IPO
premium”: an average (for each multiple) of the ratio between the implied multiple of the
valuation and the average between the multiples calculated for each peer group. Finally, a
“cross sectional regression” is carried out of the buy-hold abnormal return of each stock, from
the 22nd day after the IPO, vs the FTSE Euromid.
The results of this analysis clearly show how IBs operate a process of “left truncation” of the
peer groups, leaving out only the ones with highest multiples: if the target ratios were to be
calculated using the complete list, the IPO would have appeared to be consistently overvalued.
What’s more, stocks that would have appeared overvalued, according to the prospectus by IBs
are even undervalued, by applying a deliberate discount to the estimates. Thanks to the last
regression, then, it is shown how the greater the bias in selecting the peers, the poorer the
Long-run performance of the firm. Despite the strong results, some criticisms should be
pointed out: 1) only European market is considered in the paper, data on US IPOs are
undisclosed; 2) the last regression is carried out against a European index, without accounting
for differences within European markets; 3) It seems odd, to authors, that despite information
being public, none has ever gone short on these “overvalued” stocks.
Pitfalls in Levering and Unlevering Beta and Cost of Capital Estimates in DCF Valuation
The objective of the paper is to assess how the valuation of firms changes assuming more realistic
hypotheses that the ones underlying the Modigliani-Miller with taxes approach, so that the model
can be coherently applied in most valuation contexts. (it is already used, but incoherently). Instead
of no growth companies with fixed debt, the paper suggests to assume a company that constantly
refinance its debt and keeps the capital structure constant. Instead of a 0 beta for non-common
equity securities, the authors suggest estimating them as CAPM-implied betas starting from
estimates of non-common equity costs of capital given in another way (no regression on returns
was possible since some securities are not traded). Instead of ignoring equity linked securities, the
paper proposes to consider them in the cost of capital calculation, reducing its upward bias
(difficult because they are volatile). Finally, it is stated that contractual obligations such as leases
should be treated in the same way in all comparable. The method used is a theoretical one: theory
is followed by made up examples.
The results show how the standard hypotheses of MM with no taxes are not suitable for most firms. Sin
companies are expected to grow and therefore to issue additional debt, by setting the discount rate of i
shield equal to the unlevered cost of capital (constant capital structure) will lower the estimated value o
company.
Moreover, by setting the Betas for debt and preferred stock different from zero, the estimate
of WACC will lower and thus the estimated value for the company will increase.
Additionally, if the employee stock options, warrants and other equity-linked securities are
taken into account in computing the WACC, the result would be an increase in the WACC and
thus a drop in the companies’ value.
Finally, since the value of the companies that capitalize or expense financial obligation should
be the same, it is appropriate to standardize them across the company being valued and
compared, in order to get consistent estimates of the WACC.