OVERVIEW

Slide 1
At the start of this book, we defined an investment as a commitment of funds for a period of time to
derive a rate of return that would compensate the investor for the (1) time during which the funds are
invested, for (2) the expected rate of inflation during the investment horizon, and for (3) the uncertainty
involved. From this definition, we know that the first step in making an investment is determining your
required rate of return.

Slide 2
Investment Decision Process
- Deciding on corporate investment = shopping
1. You decide what you want
2. You examine the item
3. You decide its value or how much it’s worth to you
(If price is equal or less than the value, you buy)
except that the determination of a security’s value is more formal

Slide 3
We start our investigation of security valuation by discussing the valuation process
- Two general approaches:
a. Slide 4 topdown, three-step approach
o belief: both the economy/market and the industry effect have a significant impact on
the total returns for individual stocks
b. Slide 5 bottom-up, stock valuation, stockpicking approach
o belief: it is possible to find stocks that are undervalued relative to their market price,
and these stocks will provide superior returns regardless of the market and industry
outlook

- There are many people who endorse both of these strategies, and those who do so have seen
considerable success. However, in this discussion, we’ll be advocating for topdown, three-step
approach simply because it makes more sense – it has logic & empirical support. Investors can
succeed using the alternate approach, we’re clear on that. However, with this approach, it
would be more difficult to predict the intrinsic value of an investment as substantial information
from an analysis of the outlook for the market and the firm’s industry are ignored.

- While it is true that a security's quality and potential for profit determine its value, we also think
that the state of the economy and the success of a firm's industry have an impact on a security's
value as well as its rate of return. Consequently, we outline these factors and explain how to
take them into account when determining a security's worth.

- As we go further down the chapter, we’d be discussing more. As for now, I’d be discussing a few
important concepts to learn.
Slide 7 OVERVIEW OF VALUATION PROCESS

- Psychologists contend that a person's family, social, and economic circumstances have just as
much of an impact on their success or failure as do inherited traits. Applying this theory to the
valuation of securities indicates that the economic and industry environments of a corporation
should be taken into account when valuing it. The success of a corporation and the realized rate
of return on its stock are significantly influenced by the economic and industry environment,
regardless of the attributes or capabilities of the organization and its management.

Ex:
1. You own strong shares of the strongest and most successful firm
2. If strong economic expansion, of course sales and earnings will expectedly be high
3. If same shares but owned during major economic recession, sales and earnings will
expectedly decline

This is how important it is to also study the economy and your target industry.

Slide 8
VALUATION PROCESS – chicken & egg dilemma
Do you study the economy as a whole, or the macroeconomy, and the industry first or
do you study individual firms and then into industries and then into the entire economy?

In this discussion, we will contend that the chicken came first before the egg – that we
need to study the macroeconomy and the industry first before we break down into smaller
units. We will find more about this as we go on with the topic.
WHAT IS THREE-STEP VALUATION PROCESS?
1. Consider general economic influences
- the monetary and fiscal policies enacted by the government can directly influence
the industry in that country
Example:
• Tax credits or tax cuts can encourage spending; whereas,
• Additional taxes can discourage spending
• Government projects such as road widening can encourage industries
involved in moving of inventory or selling of products that have to be
moved from one place to another
Ex: You live in a secluded place with very bumpy roads, so you never
think of buying a (for example) Sedan. Now, the government fixed the
road and is now suitable for lower elevated cars, therefore affecting the
direct increase in demand.
• INFLATION
Inflation causes a difference between nominal and real interest rates
Nominal - the stated interest rate actually paid for a loan
Real - nominal interest rate minus the rate of inflation

The 500,000 interest you will have to pay over the next 5 years
won’t really be worth 500,000 in 5 years.

Inflation also influences the buying, saving, and investment behaviors of

Consumers and corporations.

• Economic expansion and recession

2. Consider industry influences (second step)

- The second step in the valuation process is to identify global industries that will
prosper or suffer in the long run or during the expected near-term economic
environment
- You should remember that different industries react to economic changes at
different points in the business cycle.
• For example, firms typically increase capital expenditures when they are
operating at full capacity at the peak of the economic cycle. Therefore,
industries that provide plant and equipment will typically be affected
toward the end of a cycle.
• Another example, cyclical industries, such as steel, autos, and airlines,
typically do much better than the aggregate economy during
expansions, but they suffer more during contractions. In contrast,
noncyclical industries, such as retail food and household products,
would not experience a significant decline during a recession but also
would not experience a strong increase during an economic expansion.
 - Another factor you have to consider is the DEMOGRAPHICS
Sex – 50.6% male, 49.4% female
Age – 30.7% 15 years below (young dependents), 63.9% 15-64 years old
(working age), 5.4% 65 years old and above (old dependents)
- In general, an industry’s prospects within the global business environment will
determine how well or poorly an individual firm will fare, so industry analysis should
precede company analysis.

3. Company Analysis
After determining an industry’s outlook, an investor can analyze and compare an
individual firm’s performance relative to the entire industry using financial ratios
and cash flow values. As we discussed in Chapter 10, many financial ratios for firms
are valid only when they are compared to the performance of their industries.

You undertake company analysis to identify the best company in a promising

industry.

This involves examining a firm’s past performance and, more importantly, its future
prospects. In the final step, you compare your estimated intrinsic value to the
prevailing market price of the firm’s stock and decide whether its stock is a good
investment.

Now that we have described and justified the three-step process, we need to consider the
theory of valuation.

THEORY OF VALUATION

You may recall from your studies in accounting, economics, or corporate finance that the
value of an asset is the present value of its expected returns. Diba, you expect an asset
to provide a stream of returns during the period of time you own it. To convert this estimated
stream of returns to a value for the security, you must discount this stream at your required
rate of return. This process of valuation requires estimates of: (1) the stream of expected returns and (2)
the required rate of return on the investment (its discount rate).

1. STREAM OF EXPECTED RETURNS (CASHFLOWS)

A. Form of returns
- The returns from an investment can take many forms
a. Earnings
b. Cash flows
c. Dividends (Cash, stock)
d. Interest Payments
e. Capital gains
 - We will consider several alternative valuation techniques that use different forms of returns.
Example:
1. one common stock valuation model applies a multiplier to a firm’s future earnings,
2. another valuation model computes the present value of a firm’s alternative cash flows,
3. and a third model estimates the present value of dividend payments.

- Main point is returns or cash flows can come in many forms, and you must consider all of
them to evaluate an investment accurately.

B. Time Pattern and Growth Rate of Returns

- You cannot calculate an accurate value for a security unless you can estimate when you will
receive the returns or cash flows. Because money has a time value, you must estimate the
time pattern and growth rate of returns (cash flows) from an investment. This knowledge
will make it possible to properly value the stream of returns relative to alternative
investments that have a different time pattern and growth rate of returns or cash flows.

2. REQUIRED RATE OF RETURN

A. Uncertainty of Returns (Cash Flows)
You will recall from Chapter 1 that the required rate of return on an investment is
determined by: (1) the economy’s real risk-free rate of return, plus (2) the expected rate of
inflation during the holding period, plus (3) a risk premium that is determined by the
uncertainty of returns. All investments are affected by the risk-free rate and the expected
rate of inflation because these two variables determine the nominal risk-free rate.

Therefore, the factor that causes a difference in required rates of return is the risk premium
for alternative investments. In turn, this risk premium depends on the uncertainty of returns
or cash flows from an investment. We can identify the sources of the uncertainty of returns
by the internal characteristics of assets or by market-determined factors.

INVESTMENT DECISION PROCESS: A COMPARISON OF ESTIMATED VALUES AND MARKET PRICES

To ensure that you receive your required return on an investment, you must estimate the
intrinsic value of the investment at your required rate of return and then compare this
estimated intrinsic value to the prevailing market price.

The intrinsic value of a stock is its true value. It refers to what a stock (or any asset, for that
matter) is actually worth -- even if some investors think it's worth a lot more or less than that
amount.

You should not buy an investment if its market price exceeds your estimated value because the
difference will prevent you from receiving your required rate of return on the investment. In
contrast, if the estimated intrinsic value of the investment exceeds the market price, you should
buy the investment.
In summary:
If Estimated Intrinsic Value > Market Price, Buy or Hold it if You Own It.
If Estimated Intrinsic Value < Market Price, Don’t Buy or Sell it if You Own It.