An Introduction to

Security Valuation
Course Outline

Overview of the Valuation Process

Three Step Valuation Process
Theory of Valuation
Overview of the Valuation Process

Valuation Process: part of the investment decision process in which you

estimate the value of a security
General Approaches to Valuation Process:
Top Down, Three Step Approach
Bottom Up, Stock Valuation, Stock Picking Approach
Both of these approaches can be implemented by either fundamentalists
or technicians
Fundamentalists: uses information about the economy, industry, and company
as the basis for investment decisions
Technicians: uses information such as stock price and trading volume as the basis
for investment decisions
Three Step Valuation Process

(1) examine the influence of the

general economy on all firms and
the security markets
(2) analyze the prospects for
various global industries with the
best outlooks in this economic
environment
(3) turn to the analysis of individual
firms in the preferred industries and
to the common stock of these
firms
Three Step Valuation Process

General Economic Influences

Fiscal policy: the use of taxes and government spending to affect the level of
aggregate expenditures
Monetary policy: actions taken by the nations central bank to affect aggregate
output and prices through changes in bank reserves, target interest rate, etc.
Inflation: reflects the changes in prices of goods and services
Other events such as war, political upheavals in foreign countries, or international
monetary devaluations
Three Step Valuation Process

Industry Influences
Identify global industries that will prosper or suffer in the long run or during the
expected near-term economic environment
Business cycle and industry sectors: Different industries react to economic
changes at different points in the business cycle
Structural economic changes: Demographics, lifestyles, technology, and
international exposure will have different impacts on different types of
industries
Industry life cycle: Development of an industry divided into stages
Analysis of industry competitive environment: strategic analysis
Three Step Valuation Process

Company Analysis
Purpose: to identify the best companies in a promising industry
Involves examining a firms past performance, but more important, its future
prospects
Needs to compare the estimated intrinsic value to the prevailing market price of
the firms stock and decide whether its stock is a good investment
Final goal: to select the best stock within a desirable industry and include it in
your portfolio based on its relationship (correlation) with all other assets in your
portfolio
Does the Three Step Process Work?

Studies indicate that most changes in an individual firms earnings can be

attributed to changes in aggregate corporate earnings and changes in the
firms industry
Studies have also found a relationship between aggregate stock prices
and various economic series such as employment, income, or production
An analysis of the relationship between rates of return for the aggregate
stock market, alternative industries, and individual stocks showed that most
of the changes in rates of return for individual stock could be explained by
changes in the rates of return for the aggregate stock market and the
stocks industry
Theory of Valuation

Valuation Process: part of the investment decision process in which you

estimate the value of a security
(1) Stream of expected returns: encompasses not only the size but also the form,
time pattern, and growth rate of returns
(2) Required rate of return: uncertainty of returns (risk premium)
Investment Decision Process (Conclusion)
If Estimated Intrinsic Value > Market Price, then UNDERVALUED
If Estimated Intrinsic Value < Market Price, then OVERVALUED
If Estimated Intrinsic Value = Market Price, then FAIRLY VALUED
Theory of Valuation

Example 1: An analyst determines the intrinsic value of a stock to be equal

to Php19. If the current price is Php12, the stock is most likely:
A. Overvalued
B. Undervalued
C. Fairly valued
Example 2: An analyst computes the intrinsic value of JFC stock to be in the
range of Php210 to Php214. If the current market price of the stock is
trading at Php212. The security appears to be:
A. Overvalued
B. Undervalued
C. Fairly valued