D2 Companyvaluation Ov

Toward a Factor Model of Relative Valuation
Liuren Wu
joint with Xiaolu Hu and Malick Sy
NUS Quantitative Finance Joint Seminar

11 Dec 2020
c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 1 / 23

Perform company valuation on a large universe
Investment and corporate decisions must start with an accurate assessment

of company valuation.
The finance literature talks little about (actual) company valuation, except
for textbook treatment.
Quants researchers are excited about new statistical techniques,
robo-advisors, and machine learning...
What is the right question? What’s the right performance metric?
What do you feed the machines to learn?
This project contains a large amount of manual work, just so we can find an
effective way of using the machines/techniques
Target question: fair company valuation on a large universe
Efforts: what/how to feed into company valuation

Learn from the classics
Structural DCF valuation on a single company
Works off consensus to generate variant views based on in-depth
market/industry/company analysis
Industry size, company share, industry trend, company position.
Top line growth projection
Profit margin and bottom line earnings projection
Investment and financing projection: discount rate
Potential for strategic game-changing decisions
Each analyst covers a small number of companies, and identify key
(innovative) drivers for the top/bottom line
Value multiples
Used under highly controlled environments for “comparable” companies
Key is to find the right comparables — metrics defining “comparability”
Statistical valuation of a large universe — Make the universe comparable
Transform company value into a measure as cross-sectionally
comparable as possible
Construct value determinants and conditioning metrics
cross-sectionally comparable and generally available
A factor model of company relative valuation
Objective: statistical valuation of a large universe: Make the universe comparable
Transform value into a measure as cross-sectionally comparable as possible
Value multiples (PB, PE, PS) are good starting points
Valid relative value metrics themselves within a controlled group
Identify conditions/metrics that make these multiples conditionally
comparable within a large universe
The q ratio (value/capital, or its variations) has been widely used:
Investment literature: q is the marginal value of capital
Corporate finance: q is a performance measure
Asset pricing: q (BM equity) predicts future stock returns
We use an analogous q ratio to define the relative value of a company:
q = ln((TA − BE + MC )/TA).
It reflects equity valuation, but is represented in company value space.
Company v. equity valuation (?)
The starting point of the residual income model, which considers both
what you will earn and what you have
One can, in principle, use other value multiples as the starting point...
A factor model of company relative valuation
Transform value into a measure as cross-sectionally comparable as possible
Construct determinants cross-sectionally comparable and generally available
Tons of ratios/metrics have been constructed to explain valuation
Many are variations of closely-related concepts
Each has somewhat different coverage, relevance
We propose a two-step procedure in the determinant construction
Combine/average several descriptors (of similar concepts) to one factor
The averaging can increase coverage, reduce noise, and alleviate
multi-collinearity issue
Link relative value to the constructed factors via a cross-sectional
contemporaneous regression
with controls on industry differences.
Each step has many choices/variations: Each choice raises more questions
than answers ...
If we can establish this general approach as useful, researchers can keep
working/innovating on the details down the road.
The Literature: factor model of stock returns
Our factor model is analogous in construction to factor models of stock returns
Dates back to Fama & McBeth (1973): Regress future stock returns on
some risk factors cross-sectionally.
Has been well developed in the industry (Grinold & Kahn (1999)) as the
starting point for active portfolio management
“Risk factors” are standardized firm characteristics (either return
predictors, or similarity measures).
Slope estimate represents realized return on a “factor portfolio.”
Time-series averages represent average “risk premium” estimates for
the risk factors.
Widely used for constructing “robust” covariance matrices for
portfolios optimization, and portfolio risk attribution.
Many commercial packages are available (Barra, Axioma, Bloomberg...)
Our factor model of company valuation serves different purposes:
It is a model for contemporaneous valuation, not for return forecasting:
R 2 should be much higher...
Coefficient estimate reflects market pricing of each valuation factor at
that time.
The Literature: company valuation
We teach DCF and maybe option-based equity valuation, but little empirical
work on practical implementation
Accounting literature on empirical implementations and accounting
variations of the DCF (RIM, AEG) ...
Mainly a test of inputs and long-run stationarity assumptions
Statistical regressions:
Rhodes-Kropf, Robinson, and Viswanathan (2005): Variable motivated
by RIM: Book, net income
Bartram, Grinblatt (2018, 2020): (almost) non-discriminative list of
(virtually) all BS/IS/CF entries
Edmans, Goldstein, Jiang (2012): nearest neighbors
The three papers capture three important dimensions for building a robust
statistical valuation model
Insights from structural models on value determinants
Statistical search (feature collection, construction, identification)
All models are imperfect: Local averaging/Bias-correction with nearest
neighbors — value similarity/distance measures
Descriptor construction
Our approach has all three elements: (i) structural understanding of valuation for
grouping; (ii) a comprehensive search of the literature (returns/corporate); (iii)
both value determinants and similarity measures
1 Profitability
Realized return on asset (RoA)
Analyst consensus RoA forecast
2 Growth /summary of history
Analyst long-term growth (LTG) forecasts: EPS/sales/EBIT
Growth rates over past 1 and 5 years: OI/sales
Asset expansion rate over past 1 and 5 years: TA
3 Investment
Capital expenditure, annualized CAPXQt /PPENTQt−1
Retained earnings, the ratio of retained earnings (REQ) to total asset.
Depreciation, annualized DPQ to total asset.
R&D, annualized R&D expenditure (XRDQ) to total asset.
Advertising, advertising expenditure (XAD, annual report) to TA
Descriptor construction
4 Liquidity
Working capital, working capital (WCAQ) to total asset.
Slack ratio, cash and short-term investment (CHEQ) to total asset.
Cash ratio, cash and short-term investment to current liabilities.
Quick ratio, CHEQ + accounts receivable (RECTQ) to LCTQ.
Current ratio, CHEQ+RECTQ+INVTQ to current liabilities
Trading liquidity, the log ratio of average dollar trading volume to
stock return idiosyncratic volatility (over past year).
5 Leverage: debt-to-book equity ratio
6 Market risk: 73-day daily regression beta
7 Size: log Total Asset
8 Momentum: 6-month and 12-month excluding last month
Other categories/measures/changes?

Constructing valuation factors from descriptors
At date t, there are j = 1, · · · , nk descriptors for the kth category, for
k = 1, · · · , K factors characterizing the behavior of i = 1, · · · , N companies.
j
Standardize the raw values of each descriptor, xt,i ,
j
j (xt,i − mtj )
zt,i = . (1)
stj
j
winsorize zt,i ∈ (1, 99)% to estimate (mtj , stj ), truncate zt,i
j
∈ [−2, 2].
k
Create the kth factor ft,i by averaging the nk descriptors within the category,
nk
X
k j
ft,i = wt,j zt,i (2)
j=1
with the weight estimated via a Bayesian regression:

−1 >
wt = Zt> Zt + Pt Zt Zt wtu + Pt w0 ,

(3)
wu the unconstrained estimator, w0 = 1

nk the prior, and Pt = 0.1 Zt> Zt .
Considerations: Combining descriptors to factors
ft = Zt wt (4)
I can think of three broad approaches in determining the combination weight w
Principal component analysis: Find the dominant eigenvector of Z > Z .
The factor is constructed to explain the most variation of Z .
Partial least square: Find the dominant eigenvector of Z > qq> Z
The factor is constructed to explain the most covariation Z > q.
Least square: wu = (Z > Z )−1 Z > q
Favors covariance Z > q but penalizes (Z > Z ).
Bayesian regression:
−1 >
w = Z > Z + Pt Zt Zt wu + Pw0 , P = 0.1 Z > Z

(5)
an extension of classic ridge regression to alleviate multicollinearity
What we are doing amounts to a combination of (i) (manual/structural)
clustering (instead of PCA), and (ii) Bayes least square weighting within each
cluster.
Descriptor contribution to factors
Mean Std Auto Percentile values
10 25 50 75 90
1. Profitability
RoA 0.73 0.36 0.99 0.23 0.32 1.00 1.00 1.00
RoA forecast 0.72 0.10 0.84 0.61 0.66 0.71 0.78 0.87
2. Growth
LTG forecast 0.46 0.09 0.96 0.33 0.38 0.47 0.53 0.57
Growth 5Y 0.12 0.08 0.91 0.01 0.08 0.13 0.17 0.21
Growth 1Y 0.19 0.07 0.77 0.11 0.14 0.18 0.23 0.27
Expansion 5Y 0.14 0.16 0.97 -0.03 0.03 0.10 0.23 0.40
Expansion 1Y 0.17 0.08 0.86 0.07 0.11 0.15 0.22 0.27
3. Investment
Expenditure 0.28 0.07 0.94 0.18 0.24 0.27 0.33 0.37
Retained earnings 0.25 0.12 0.99 0.11 0.15 0.20 0.37 0.42
Depreciation 0.11 0.08 0.97 0.01 0.05 0.10 0.16 0.23
R&D 0.32 0.13 0.97 0.11 0.24 0.34 0.40 0.49
Advertising 0.19 0.09 0.97 0.08 0.12 0.17 0.25 0.33

Descriptor contribution to factors
Mean Std Auto Percentile values

10 25 50 75 90
4. Liquidity
Working capital 0.27 0.07 0.97 0.19 0.21 0.26 0.33 0.37
Slack ratio 0.33 0.09 0.96 0.22 0.27 0.32 0.39 0.45
Cash ratio 0.04 0.12 0.95 -0.11 -0.06 0.03 0.13 0.20
Quick ratio 0.09 0.09 0.92 -0.02 0.02 0.08 0.14 0.21
Current ratio -0.05 0.06 0.87 -0.14 -0.10 -0.05 -0.00 0.03
Trading liquidity 0.32 0.09 0.98 0.18 0.25 0.34 0.38 0.41
8. Momentum
Momentum 1Y 0.60 0.14 0.83 0.42 0.50 0.61 0.69 0.77
Momentum 6M 0.40 0.14 0.83 0.23 0.31 0.39 0.50 0.58

A factor model of company valuation
At each date t, link the standardized relative value of N companies, qt , to

their K factors, Ft , and industry dummy Gt ,via a cross-sectional regression,
qt = Gt dt + Ft ct + et , (6)
dt : the average normalized relative value at time t for each industry.

Ft : time-t firm characteristics that determine company relative value.
ct : the time-t market pricing of each value-characteristic factor.
Caveats and extensions
Additive Gt : Industry can have average value differences (nearest
neighbors control), but all share a common factor structure
Multiplicative: Allow different factor structures across industries
Cascade structure: Industry classification does not need to be binary.
Statistical learning:
(relevant) feature identification as valuation factors
Nonlinear, non-additive mapping

Model performance
A. Full-sample performance B. In and out-of-sample performance
Full-sample R 2 average 68%, reasonably stable across market conditions

Some degeneration during recessions.
Out-of-sample: Divide the sample into two random halves. Estimate the
relation on one half; measure performance on the other out-of-sample half.
Mild out-of-sample degeneration: 65% out-of-sample v. 68% in-sample
What’s the right out-of-sample setting/performance metric?
Market pricing of valuation factors
Profit and growth Investment and liquidity
Leverage and beta Size and momentum
Profit, growth, investment, liquidity have positive and stable contributions.

Momentum is another estimator for growth.
Contributions from leverage and beta are small, and compensate each other
– intricate interactions between risk, growth, and profitability ...
Size effect is negative, declining marginal benefit of investment?
How do market pricing and performance vary over time?
Rate TS CS Vol Value Profitabi
Market pricing of valuation factors
Profitability 0.32 ( 0.25 ) 0.91 ( 2.40 ) -0.33 ( 0.73 ) -0.15 ( 0.25 ) -2.36 ( 2.62 ) -3.06 ( 2.
Growth -1.84 ( 1.54 ) -1.07 ( 2.58 ) 0.84 ( 2.00 ) 0.04 ( 0.07 ) 3.24 ( 4.12 ) 1.21 ( 3.
Investment -0.24 ( 0.42 ) 0.50 ( 1.28 ) -1.54 ( 3.53 ) 0.92 ( 1.71 ) -1.73 ( 2.36 ) 1.16 ( 1.
Liquidity 0.90 ( 1.75 ) 0.32 ( 0.58 ) -0.52 ( 1.26 ) 0.42 ( 1.04 ) -0.24 ( 0.43 ) 1.23 ( 3.
Leverage 1.03 ( 1.94 ) -0.09 ( 0.26 ) 0.24 ( 0.60 ) 0.49 ( 1.48 ) -4.04 ( 8.65 ) 0.65 ( 3.
Market risk -1.64 ( 1.43 ) 0.31 ( 0.34 ) -0.17 ( 0.20 ) 2.63 ( 3.96 ) 6.37 ( 6.19 ) -0.88 ( 2.
Size 0.34 ( 0.68 ) -0.44 ( 1.40 ) -0.66 ( 1.83 ) 0.28 ( 0.59 ) -0.84 ( 1.64 ) -1.14 ( 4.
Momentum 2.30 ( 1.96 ) -0.67 ( 1.29 ) 1.61 ( 1.93 ) 1.39 ( 2.45 ) 3.42 ( 3.86 ) 0.97 ( 1.
Valuation model explanatory power

Performance -1.25 ( 2.38 ) -0.42 ( 1.70 ) -0.11 ( 0.44 ) -0.27 ( 0.78 ) 3.15 ( 6.41 ) -0.55 ( 2.
hard to draw clear conclusions yet, but worth more research ...
What are the market condition metrics that affect the pricing of different
factors the most? Why?
The cross-sectional model defines “fairness” as fitting the average at that
time — What is actual is rational
How to define and test the “fairness” of the pricing of each valuation factor?
Applications
Relative value decomposition:
qt = Gt dt + Ft ct + et , q
bt = Gt d̂t + Ft ĉt , qt = q
b t + et
qt — relative value, q
bt — fair value, et — misvalue
Outside investors can use the model to identify misvaluation as investment

opportunities — the definition of value investing
Profit-seeking trades can make previously-identified return predicting
relations disappear, but will make a valuation model “more accurate.”
Internal management can use the model in its corporate decisions:

Dynamic capital structure rebalancing: Increase debt/buy back stock
when fair equity value appreciates
Should we compute dynamic hedging ratios on actual value or fair
value of a contract?
Market-timing: Issue more stocks when stocks are over-valued — the
opposite direction of rebalancing: risk on v risk off
Fair/mis-value effects on investments, merger and acquisitions, stock
takeovers, ...
Value investing via decile portfolios
Average annualized monthly returns and (t-statistics)

Horizon Monthly returns
Rank Relative value Fair value Misvalue
1 0.179 ( 5.72 ) 0.142 ( 4.72 ) 0.183 ( 6.24 )
2 0.170 ( 6.28 ) 0.145 ( 5.71 ) 0.177 ( 6.30 )
3 0.150 ( 6.20 ) 0.136 ( 5.61 ) 0.155 ( 5.74 )
...
8 0.125 ( 4.58 ) 0.148 ( 5.42 ) 0.118 ( 4.82 )
9 0.113 ( 3.99 ) 0.127 ( 4.23 ) 0.111 ( 4.22 )
10 0.117 ( 3.55 ) 0.151 ( 4.41 ) 0.073 ( 2.67 )
1-10 0.062 ( 2.11 ) -0.009 ( -0.30 ) 0.110 ( 7.83 )

FF4-Alpha 0.060 ( 4.39 ) -0.018 ( -1.15 ) 0.105 ( 10.35 )
Fair value component of relative value ratio does not predict return
Return prediction comes solely from the misvalue component

Value investing in a factor return structure
Coefficient estimates from cross-sectional stock return forecasting regressions:
rt+1 = Gt ηt+1 + Ft ( or Et )ϕt+1 − et ζt+1 + εt+1 , (7)
Company relative value factors Ft Equity return risk factors Et

Factors Monthly Factors
Quarterly Monthly
Profitability 0.018 ( 3.74 ) 0.016 ( 3.16 )
Growth -0.012 ( -2.10 ) -0.014 ( -2.24 )
Investment -0.003 ( -0.73 ) -0.001 ( -0.19 )
Liquidity -0.004 ( -1.16 ) -0.005 ( -1.24 )
Leverage 0.002 ( 0.42 ) 0.003
Beta ( 0.76 ) -0.008 ( -0.82 )
Market risk -0.002 ( -0.32 ) 0.001 cap
Market ( 0.16 ) -0.009 ( -1.62 )
Size -0.006 ( -1.09 ) -0.005 ( -0.96 equity
Book-to-market ) 0.008 ( 1.26 )
Momentum 0.007 ( 1.12 ) 0.009
Momentum ( 1.33 ) 0.021 ( 2.74 )
Misvalue 0.036 ( 8.10 ) 0.024

Misvalue ( 5.18 ) 0.030 ( 7.70 )
Returns on misvaluation show similar t-stats, with or without controlling for

company valuation or equity return risk factors.
The role of valuation in equity financing decisions
Equity financing decision: Change from the previous quarter to next

quarter/total asset at valuation date
Misvaluation: de-biased from one-year moving average
Fair value Misvalue
Net equity issuance -0.25 ( -2.52 ) 1.91 ( 10.02 )
Equity issuance -1.18 ( -3.67 ) 3.77 ( 8.28 )
Equity purchase 0.38 ( 5.92 ) -0.92 ( -7.81 )
Issuance-purchase -1.38 ( -4.78 ) 4.41 ( 9.64 )
Effects of misvaluation: Strong and consistent across both net and separate
issuance/purchase measures.
Issue more, purchase less when stocks are over-valued.
Effects of fair valuation: strong and opposite
Issue less, purchase more equity when the fair value becomes higher.

Dynamic rebalancing v. market timing
Equity issuance/purchase can be used to serve two different purposes:
Dynamic rebalancing toward a leverage target
When MC/relative value increases, the company’s leverage declines.
To rebalance toward its original leverage target, the firm needs to
increase its leverage and can do so via stock repurchase.
Dynamic rebalancing can remove a lot risk without many contracts,
wins Scholes/Merton a Nobel in hedging derivatives risk, and can be a
good guide for corporate policy to the extent transactions are possible
Market timing to benefit from misvlauation
When market cap (and hence relative value) is higher than fair, the
firm can take advantage of the misvaluation opportunity by issuing
more equities at the higher-than-fair valuation.
This market-timing operation makes the firm deviate further from its
leverage target (original leverage level) — (α/β) trade-off
Our results show that the rebalancing operation dominates when the relative
value variation is fair and is hence more permanent.
The market timing operation dominates when the relative value variation is
driven by temporary misvaluation.
Concluding remarks
We strive to build a statistical company valuation factor model structure
that can be applied to a large universe
A detailed DCF projection needs domain expertise and works better
with a singular focus on a selected number of companies.
The statistical valuation approach benefits from a large sample size for
more robust estimation.
The two complement each other, and can help each other.
The valuation factor structure is analogous to the stock return factor model
structure that has been widely adopted/commercialized in the industry.
The two factor models serve very much different objectives:
One for valuation; the other for risk attribution.
The valuation factor model structure is much stronger, much more stable,
and much better positioned to benefit from the many new statistical and
structural developments
and can be the starting point for investment, financial service, and
corporate policy analysis
A lot more can be done on target construction, feature selection, estimation
setting, performance metrics...

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Toward a Factor Model of Relative Valuation

NUS Quantitative Finance Joint Seminar

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 1 / 23

Investment and corporate decisions must start with an accurate assessment

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 2 / 23

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 9 / 23

with the weight estimated via a Bayesian regression:

wu the unconstrained estimator, w0 = 1

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 12 / 23

Mean Std Auto Percentile values

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 13 / 23

At each date t, link the standardized relative value of N companies, qt , to

dt : the average normalized relative value at time t for each industry.

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 14 / 23

Full-sample R 2 average 68%, reasonably stable across market conditions

Leverage and beta Size and momentum

Profit, growth, investment, liquidity have positive and stable contributions.

Valuation model explanatory power

Outside investors can use the model to identify misvaluation as investment

Internal management can use the model in its corporate decisions:

Average annualized monthly returns and (t-statistics)

1-10 0.062 ( 2.11 ) -0.009 ( -0.30 ) 0.110 ( 7.83 )

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 19 / 23

Company relative value factors Ft Equity return risk factors Et

Misvalue 0.036 ( 8.10 ) 0.024

Returns on misvaluation show similar t-stats, with or without controlling for

Equity financing decision: Change from the previous quarter to next

c Liuren Wu (Baruch) Company Valuation 11 Dec 2020 21 / 23

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