Over Valuation

 When the stock sells for more than its intrinsic value
 Intrinsic value is basically an estimation of what the stock is truly worth.
 There are some indicators like P/E ratio(price index divide by stock market),
Market cap of corporate equities divide by nation’s GDP, returns you get in
market Vs others assets i.e. the inverse of P/E ration which is stock earnings
divide by price index whether it is over valuated, under valuated or fair price.

Empirical evidence suggests that stock markets are semi-strong efficient i.e. equity
prices reflect all publicly available information. However, this does not necessarily
mean that the shares will be fairly valued:
 If the market doesn’t fully understand the information available
 It tends to overestimate the potential returns and so overvalue the
equity.
 The price of overvalued equity may not be corrected by the market if:
 The data provided by managers is deliberately misleading; a particular
problem where the agency relationships within companies breaks down
 There is collusion by gatekeepers including investment and commercial
banks, and audit and law firms (many of whom have been accused of
knowingly contributing to the Misinformation and manipulation that fed
the overvaluation of stocks such as Enron and World com amongst
others).

Problems of overvaluation

A share is overvalued if it is trading at a price that is higher than its underlying value.
In an efficient market this can still occur if:
 the market doesn’t properly understand the business and overestimates the
expected returns
 the managers running the company do not convey full company information
honestly and accurately.
 The price has been inflated to an extreme point, expectations are higher than
ever, but actual results are not yet produced by the company
 Bubble is caused when the price of a stock is increasing and increasing
without any real arguments to justify the price increase.

Management responses to overvaluation

Managers may be reluctant to correct the markets’ mistaken perceptions. This can
lead to:

 the use of creative accounting to produce the results the city is expecting
 poor business decisions aimed at giving the impression of success
 ‘poor’ acquisitions made using inflated equity to finance the purchase.
The response of management

When a firm produces earnings that beat analysts’ forecasts, the share price rises by
5.5% on average. For unexpected negative earnings, the share price falls on
average by 5.05%. Even where shares are fairly priced shares, managers may hide
the inherent uncertainty in the business by smoothing earnings figures – delaying
expenses and bringing forward revenue recognition, for example to ensure they
consistently meet investor expectations.
If equity remains overpriced, the company will not be able to deliver – except by pure
luck – the performance to justify its value. Where the management of an overvalued
company is unwilling to accept the pain of a stock market correction, earnings
smoothing can escalate into false accounting and outright lying. In addition, projects
that give the appearance of potential earnings may be adopted even where the true
likely outcome is a negative NPV, in order to forestall city concerns.
Research has also shown that companies are more likely to make acquisitions when
their shares are overvalued. This is because they can use the shares to buy assets
(which have true worth). However, these mergers often do not make good business
sense and can destroy the core value of the firm.

 N.B: The financial data the managers supply should be treated with
caution .i.e. manipulation of earnings

Case study

At the time of Enron’s peak market value of $60 billion, the company was worth
about 70 times its earnings and 6 times its book value of assets.
The company was a major innovator, and the business had a viable future. However,
senior managers were unwilling to see the excess valuation diminished. Rather than
communicate honestly with the market to reduce its expectations, they tried to hide
the overvaluation by manipulating the financial statements and exaggerating the
value of new ventures. By the time the market had realised the extent of the
problem, the core value of the company had been destroyed.

Implications for valuations

In valuing a company, reported results form an essential core of data.

Since reported earnings may be manipulated to produce more favourable results
(aggressive accounting) the financial statements should be scrutinised and restated
as necessary before being used as the basis for any valuation.
The detailed techniques are outside the syllabus but would include:

 Calculating the Cash to Operating Profit (COP) ratio. This involves comparing
EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation) with
operating cash flow – they should be about equal.

A figure above one is an indicator of aggressive accounting.

 Adjusting for changes in: – depreciation/amortisation policy – bad debt

provisions.
  Considering whether the amortisation of intangibles and R&D is appropriate
and adjusting if necessary.
 Making changes if necessary to the way leases and hire purchase
agreements have been accounted for: – Removing any exceptional items. –
Removing any exceptional payments such as directors’ severance payments.

High growth start-ups

A start-up business that wishes to attract equity investment will need to put a value
on the business.

Valuing start-up businesses presents a different challenge from valuing an existing

business, because unlike well-established firms many start-ups have:

 little or no track record

 ongoing losses
 few concrete revenues
 unknown or untested products
 little market presence.
 inexperienced managers with unrealistic expectations of future profitability
 Lack of past data makes prediction of future cash flows extremely difficult.
 Any mathematical valuation will inevitably be only an early starting point in the
negotiations.

Estimating growth

Growth for a start-up can be estimated based on:

 industry projections from securities analysts
 Qualitative evaluation of the company’s management, marketing strengths
and level of investment.

However, both of these are essentially subjective and are unlikely to be reliable.
Since high-growth start-ups usually cannot fund operating expenses and investment
needs out of revenues, long-term financial projections will be essential.

High growth is one thing, profitable high growth is another.

Growth in operating income is a function of:
 management’s investment decisions:
 How much a company reinvests.
 The effectiveness of the investment in achieving results.
 the markets acceptance of the product and the action of competitors
 management's skills
 the riskiness of the industry.

Valuation methods
Since the estimate of growth is so unpredictable and initial high growth can so easily
stagnate or decline, valuation methods that rely on growth estimates are of little
value:
 Cash is key indicator of start-up success and asset models are therefore an
important starting point.
  However, they cannot provide an accurate value, since value rests
more on potential than on the assets in place:
 DCF models are problematic because of the non-linear and unpredictable
performance often exhibited in the early years, rendering the estimates highly
speculative.
 Market based models are difficult to apply because of the problem of finding
similar companies to provide a basis for comparison.