Reading 1) PITFALLS IN UNLEVERING AND LEVERING BETA

- The author is examining the formulas to unlever/lever beta and compute the cost of
capital.
- The approach the author follows is that of examining the traditional formulas to find
out what their potential pitfalls are.
- The theory the author wants to corroborate is that such formulas might present a
few issues.
o The author criticizes the conventional approach of setting the beta of the
debt and the preferred securities to 0, which is incorrect as it would imply
that the cost of debt would have to be the risk free rate. In fact, such
approach would underestimate the cost of capital, which would increase the
firm’s valuation. This is in contradiction to some basic corp fin rules.
o Furthermore, the author examines the potential consequences on valuation
of not considering equity linked securities (warrants, convertible debt …). This
would imply a lower cost of capital, which would increase the firm’s valuation
with respect to its real value. However, considering such securities could be
problematic as they are inversely correlated to the stock price.
o The author also highlights that discounting future interest tax shields at a rate
equal to the current cost of debt would be inappropriate, since the ones
originating from future debt issues are riskier than the firm’s current debt.
The more appropriate choice would be the unlevered cost of capital.
o The paper also acts as a critique to Modigliani-Miller post tax formula.

The Modigliani miller assumptions may not be too appropriate: stable firm, fixed amount of
debt issued, constant future tax rate , its discounted at kd, …). All of this approaches are in
direct contradiction to the fundamental principle for the WACC approach to bring to similar
results for a growing firm.

Moreover, the author analyses the unlevered cost of capital of a firm that capitalizes its
operating leases and compares it with that of a firm that doesn’t. what he discovers is that
the firm that capitalizes its operating leases has a lower unlevered cost of capital, but an
equal equity cost of capital, which implies an higher valuation.

Limitations: solutions are somewhat hard to implement.

2) IPO VALUATION AND PEERS

- In this paper, the authors examine the choice of peers by underwriters during an IPO
and try to prove that this choice is biased. Indeed, the underwriters show a tendency
to exclude underwriters that would make the IPO look overvalued, in order to
influence investor’s demand and market price. The underwriters’ goal is that of
maximizing the difference between preliminary offer price and subsequent market
price. If the difference were to be low, investors would be optimistic, which would
be beneficial for the firm but would produce low long term returns.
 - To do this, they study a sample of 361 IPOS from France, Germany, Italy between
1999 and 2012. They choose this sample of IPOS between all the ipos in which
Comparables and their relative prices were observable. They compare the peers
used preliminary by underwriters with the peers selected through 5 alternative
selection methods (algorithmic or non algorithmic):
Thomson one banker
Ev/sales matching w public companies
Propensity score matching
Underwriter’s post-ipo valuation
Valuation by other sell side analysts post ipo
- From this calculation, they compute three indexes: VALUATION BIAS, which is the
comparison between the multiple used by the underwriters and the one used by
alternative methods, IPO PREMIUM, BUY AND HOLD ABNORMAL RETURNS, which is
the return of the firm vs the market.
- They do several robustness checks
- They also analyse the case of Ferretti, an IPO which showed significant valuation bias
and IPO premium

- What they discover is that there is a significant valuation bias, which ranges from
13% to 38%. There is also a significant IPO premium.

- This is obtained by underwriters by left truncating the sample of comparables.

Precisely, the “lowest” underwriters’ multiple will be higher, so that
- The sample of ipo is compared to a benchmark: precisely, in 3 years they
underperform it by 15%, in 5 years by 26%. The higher the valuation bias, the lower
the return.

LIMITATION:
- Doesn’t focus on US Peers
- Valuation is a art and not a science

EU AND US MULTIPLES
The authors examine the accuracy of relative valuation (where accuracy is the difference
between theoretical prices and actual market price) and if there are country differences in
such valuations.
The paper starts with identifying the most commonly used multiples for financial institutions
(PBV, PTBC, Pdividends, Pdeposits, PE in its 6 expressions) and with a review of the
literature which had ranked multiples from the most to the least accurate.
After that, the authors use a sample of 1118 EU and US banks from 1990 to 2018. For each
bank, they compute the “out of sample” multiples, their mean, and they multiply it by the
bank’s corresponding value driver to obtain the theorical price. They then compute the
error of this theorical price wrt to the market to compute the accuracy of these multiples.
The authors also examine whether the introduction of the euro as a common currency
increased the multiples accuracy, and on the opposite, what were the effects of the financial
crisis.
The results and conclusions of the paper are that:
- Us multiples are on average more accurate than the eu
- Large commercial banks multiples are on average more accurate than small
commercial banks.
- The 2 years forward P/e multiple is the most accurate
- Earnings’ Multiples are more accurate when earnings don’t include extraordinary
items.
- P commondividends are more accurate than p totaldividends

SCENARIO ANALYSIS DECISION TREES MONTECARLO SIMULATIONS

Damodaran analyses whether the value of an investment can be computed in an alternative
way to the most traditional one of obtaining one single value that encapsule all the future
expected outcomes. Precisely, he analyses three alternative methods: scenario analysis,
decision trees, montecarlo simulations.

The scenario analysis consists of analysing all possible future outcomes, assigning a value to
each,assigning a probability to each and determining cash flows and valuation for each of
these scenarios. The advantage is that it allows to find a range of values, and the size of the
range is a good indicator of the standard deviation (and therefore the risk) of the
investment. However, there is a tradeoff between number of scenarios and precision of the
estimation.
The decision trees analysis is an analysis which consists on dividing the analysis in
subsequent risk phases (each represented by a node), give value to each final node and
computing the initial value by folding back the tree. This is appropriate when the risk is
discrete and subsequent, and its advantages are that the final range embeds the risk, that it
has a dynamic approach to risk (and therefore it is appropriate for risk management), but it
does not take current risk into account.
For Montecarlo simulations, the analysis consists on finding a small number of inputs which
show little to no correlation between them, find their distribution and run a simulation from
this. This analysis is well suited for continuous risk, provides a deeper and more accurate
input estimation, gives a result which is a distribution of expected values and not a point
estimate. However, it may be that real data is not compatible with theorical statistic
distribution and statistical hypotheses.

Overall, the more traditional methods may not always be the more appropriate in
computing the value of an investment, especially when risk is dynamic and path related.

PRIVATE BENEFITS OF CONTROL

The authors examine the private benefits of control, which they argue is a real and
measurable phenomenon, and the country difference between those. The paper argues that
such benefits are higher in less developed capital markets, with concentrated ownership
and a higher number of privately negotiated transactions.

Literature describes private benefits as made of three components: perquisites, dilution,

psychic value. Moreover, literature has described two ways to measure them:
 - Barclay and Holderness: they measure a control premium by focusing on public firms
firms whose controlling block is transferred privately: the difference between…
- Rydqvist: describes as the difference.
The authors choose the first, and analyse their theory by choosing a sample of 393
transactions in 39 countries between 1990 and 2000, which respect the following
characteristics: they involve a transfer of control block votes, their prices are observable and
non restricted by regulations.,
They also check for the potential influence of deal or firm specific characteristics and check
the effectiveness of their estimates by comparing them with other methods.

What they find is that the average control premium is 14%, 25% in 10 countries, 3% in 14
countries. Indeed, the countries in which ….
They reject the hypothesis that such control premium came from overpayment, superior
information, liquidity differences between countries.
Good acc stds, high tax compliance, high protection of minority shareholders, high law
enforcement, product market competition.

GLOBALIZATION
The paper analyses the impact of globalization of capital markets on the cost of capital and
therefore on valuation of assets/investments. The authors follow both a theorical (analysis
of the literature) and a practical approach (examples, simulations, time-series analysis).
The paper starts from a “close” market, where the use of a LOCAL CAPM would be more
appropriate, and moves towards an open market. In such market, the cost of capital will be
lower and therefore the valuation will be higher.
This happens mostly because the investors are able to diversify, which means that the
required return on equity decreases. In fact, the possibility of diversifying decreases the risk
but leaves the expected return on equity unchanged. This implies a lower cost of capital,
and therefore a higher valuation. The use of a global capm would be more appropriate.
Globalisation allows to raise capital with better terms and reduces cost of external financing.
In fact, it improves corporate governance and management monitoring, thus decreases
information costs and agency costs, which is another reason why the cost of capital
decreases.
Globalisation also decreases transaction costs, makes markets more efficient, improves
information spreading.

CORPORATE VOTING RIGHTS

The paper tries to estimate value of corporate voting rights and whether those differ across
countries. It also tries to find a link between the value of corporate voting rights and the
legal environment of a country
The authors analyse the previous literature:
- Modigliani and Perotti had found a weak negative correlation between control
premium and law enforcement. However, their analysis was single country
- Rydqvist an Zingales had calculated.
Following what suggested by the two approaches , the authors analysed a sample of more
than 600 dual-class firms in the 18 largest capital markets in 1996-1997, and adjusted their
measure for:
Probability of takeover, block holding cost, difference between dividend and liquidity rights
among shares.
Moreover, they study the significance of:
- Takeover regulations
- Law enforcement
- Charter provisions
- Investor protection

What the authors find is that the control block votes have a value of 48% in sk, -2.88 in HK
and they are quite high in other countries such as Brazil and Italy, Moreover, control block
of votes have a higher value in countries with a weaker legal system and lower minority
investor protection, because it is easier for control shareholders to extract private benefits.

ORDINE
1) EU AND US BANKS VALUATION
The paper examines the accuracy of relative valuation for EU and US banks.
Precisely, accuracy is the difference between the theorical price implied by a
multiple and the real market price of the financial institution.
To do this, the authors first present the most common multiples used to value
financial institution: PBV, PTBV, PDividends, PDeposits, PE (in its 6 versions). Then,
they present past literature that had tried to rank these multiples (forward PE) from
most precise to least precise (PSales).
To calculate the accuracy of the multiple, the authors select a sample of more than a
thousand US and EU banks (divided into IBs and (large and small) commercial banks)
between 1999 and 2018. For those banks, they calculate the out of sample multiples
(multiple computed by taking the bank under exam out of the sample), calculating
their mean and multiplying it by the corresponding value driver of the financial
institution. They then calculate the error of this theorical price wrt the market price.
The authors also calculate how the multiples’ accuracy was affected by major events
such as the introduction of the euro and the financial crisis.
What they find is that:
o The 2 Yrs forward PE multiple is the most accurate.
o PBV is surprisingly more accurate than PTBV
o PCommondividends is more accurate than PTotalDividends
o Earnings should be calculated without extraordinary items
o The introduction of the euro overall increased multiples accuracy, whereas
the financial crisis overall decreased it.
o US multiples show a higher accuracy
o Large commercial banks multiples are the most accurate.

2) SCENARIO ANALYSIS, DECISION TREES, MONTECARLO SIMULATION

 The paper examines alternative methods to value firms and investments. Specifically,
often finding one single value that encapsulates all future expected outcomes is not
the most appropriate choice. For this reason, Damodaran examines three alternative
methods.
o Scenario analysis: consists of predicting the number of possible future
outcomes, their probability, and calculating the relative cash flows and
valuation. This method allows to find a range of possible values, and the size
of such range is a good indicator of the risk of the investment. However,
there is a tradeoff between number of scenarios and precision of the
estimate.
o Decision trees: it is a method which fits discrete and subsequential risks. The
logic is dividing the analysis into risk centers (represented by the nodes);
from each risk center will depend a number of outcomes. The analysis assigns
a value to each final outcome and then assigns value to the various nodes by
folding back the tree. Just like the previous analysis, it also allows to find
values within a range. Moreover, it allows to study the risk of the investment
and is a better fit for an investment whose risk changes and therefore it is
perfect for risk management. However, it does not take concurrent risks into
account.
o Montecarlo simulations: it is perfect for modeling continuous risk. The
simulation consists in finding a small number of uncorrelated variables to use
ad inputs, finding their distribution, and running simulations with those. The
fact that it requires analysis on the input variables allows for a more precise
estimation. Moreover, the output is a distribution and not a point estimate.

3) PRIVATE BENEFITS OF CONTROL

The papers’ thesis is that private benefits of control are a real and measurable
phenomenon, and that they are different between countries.
Literature had defined private benefits of control as made of various components:
psychic value of being in control, present values of opportunities. Moreover,
Barclay and Holderness had defined a method to value private benefits of
control which consisted of focusing on privately held negotiations of publicly traded
companies and calculating the control premium
Rydqvist and Zingales, instead, focused on another method, which consisted in
calculating the difference.
The paper chooses the first one, as the second would exclude all countries which
don’t allow dual class firms.
For this reason, it selects a sample of 393 transactions in 39 countries between 1999
and 2012. Those transactions need to respect some criteria: negotiations need to
include control block votes; prices have to be observable and not restricted by
regulations.
The paper also checks for the effect of firm and deal specific characteristics.
What it finds is that the average control premium is 14%, higher than 25% in 10
countries, lower than 3% in 14 countries. This implies that less developed capital
markets, with a higher number of private transactions, and with a more
concentrated ownership have a higher value of private benefits of control. On the
other hand, countries with better accounting standards, a better legal environment,
 a better protection of minority stakeholders, a better public market competition, and
a higher rate of tax compliance have lower value.
The paper also rejects that those numbers come from overpayment, superior
information or liquidity difference between countries.

4) GLOBALISATION
The paper analyses the effects of globalization on cost of capital and therefore
valuations, and it argues that globalization has overall decreased it.
The paper does that through a theorical approach and a practical one.
First, it introduces a “closed” market where the local investor can’t diversify by
investing in foreign stocks. In such market, an approach such as the Local CAPM
would be more appropriate.
If the market were “open”, instead, investors would have a lower required return on
equity: in fact, by diversifying, their investment could have a lower risk and maintain
the same expected return. In such context, an approach like the global CAPM would
be more appropriate. For this reason, the cost of capital would be lower, and
valuations would be higher.
Moreover, globalization has made it easier to raise capital with better terms and has
lowered the cost of external financing. In fact, it has improved managerial
monitoring and corporate governance and has therefore it has lowered agency cost
and information asymmetry.
Globalisation has also made markets more efficient, made the “flow” of information
easier, reduced transaction costs.

5) IPO VALUATION
The paper argues that the choice of peers made by underwriters to value an IPO is
biased. Indeed, underwriters exclude peers that would make the IPO look
overvalued. By doing this, investors are oftern overly optimistic, which definitely
benefits the firm in the short term, but results in a lower long term performance of
ipos.
To demonstrate this, the authors analyse a sample of more than 300 IPOs in Italy,
France, gERMANY, in which the comparables and the relative multiples were
observable. They then compare the peers used by underwriters with peers chosen
through 5 alternative selection criteria: Thomson one banker database, Ev/sales
matching with public companies, propensity score matching, post-ipo analysis by
underwriters, post-ipo prospects by other sell side analysts.
From these comparisons, they compute three measures:
The valuation bias, which expresses the difference between multiples computed
through the underwriters comparables and those with the alternative method.
The ipo premium, which expresses the difference between the preliminary offer
price and that obtained through …., buy and hold abnormal returns.
They also use the case of Ferretti, which
What they find is that the average valuation bias is between 13% and 38%. Also, ipos
perform 15% poorer in 3 years and 26%. Underwriters infact achieve this by “left
truncating” their choice. This means that the lowest multiple of the underwriter will
be and therefore the ….
6) CORPORATE VOTING RIGHTS
The authors compute the value of corporate voting rights and private benefits of
control and whether there exist country differences between those. They also
compute whether such value is different between countries.
Instead of computing the value of a single share, they compute the value of a block
of voting shares (or control block votes) in aggregate.
The previous literature had already analysed the value of corporate voting rights:
a. Modigliani and Perotti had already found the relationship (negative) between
legal environment and value of such rights
b. Zingales and Rydqvist had tried computing the value of corporate rights by
analysing
Starting from both these sources, the authors take a sample of more than 600 dual
class firms in the 18 largest capital markets, from which they calculate the existance
of a premium between the two classes of shares, and adjust this measure for
takeover probability, block holding costs, difference in liquidity and dividends among
stocks. They also check the correlation between value and some variables such as:
investor protection, takeover regulation, law enforcement, charter provisions.
What they find is that the control premium varies among countries: it’s high in
countries like Italy and brazil, it’s maximum in south korea (48%) and minimum in
hong kong (-2,88%). They also find that the R2 of those variables is 68%. Overall,
there is a negative correlation between … the logic is that in places , the oprotection
of minorities and so it will be easier for

7) PITFALLS IN UNLEVERING BETA

The paper’s aim is that of stating that the formula for levering and unlevering beta
might not be the most appropriate and might be based on a series of wrong
assumptions.
For instance, the hypothesis that the beta of debt and preferred securities and 0, is
inconsistent with that of considering a cost of debt which is different from the risk
free rate. Moreover, the use of the cost of debt to discount future expected its is
also partially inappropriate, since those depending on future debt issuances is