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Advanced Equity

Analysis (FNCE6019)
Singapore Management University (SMU)
Lee Kong Chian School of Business (LKCSB)
Seminar 1
Introduction & Overview
Why Valuation?

This Course on Advanced Equity Analysis is about how to

value an asset.
Every asset, financial or real has a value.
Investment professionals spent a great deal of time
determining the value of a particular asset.
The key to successfully invest in and manage these assets
lies in understanding the value, and its sources.
Hence, valuation plays a key role in many areas of finance:
Corporate Financial Management (investment, divestment &
financing decisions)
Portfolio Management
Mergers & Acquisition

The valuation uses either variables that can predict future
investment returns or comparisons to other, similar assets to
estimate the assets value.
Those who are skilled at determining the value of an asset have
a greater chance of investing success.
Carrying out a valuation exercise provides a financial road-
map along which value will be created.
Valuation methodology provides a range of tools, but we must
remember that it is not an objective exercise; any
preconceptions and biases will find its way into the value.

Valuation plays a key role in many areas of Finance

A Philosophical View on Valuation

Some investors believe that the pursuit of true value based

on financial fundamentals is a fruitless one in markets where
prices often seem to have little to do with value.
There have always been investors in financial markets who
have argued that market prices are determined by the
perceptions of buyers and sellers, and not by anything as
prosaic as cash flows and earnings.
Perception matters, but they cannot be all that matter.
Asset prices cannot be justified by merely using the bigger
fool theory.

We should not justify a price simply because there

is someone willing to pay it.
What is Value?
Intrinsic Value (V) the value of an asset given a
hypothetically complete understanding of the assets
investment characteristics true or real value
Does Market Price (P) reflects the Intrinsic Value?
Efficient Market Theory is the market price the best
available estimate of its intrinsic value?
Grossman-Stiglitz paradox
Rational efficient markets formulation (Grossman-Stiglitz, 1980)
There are distinctions among the levels of market efficiency
in different markets or tiers of markets
Alpha or Abnormal Returns
Any departure of market price from the active managers
estimate of intrinsic value (VE)is a perceived mispricing.
VE P = (V-P) + (VE-V)
Modern Security Analysis
Classic Concepts
Graham and Dodd (Security Analysis, 1934)
Stock investment required orderly, comprehensive, and critical
analysis of a companys income account and balance sheet.
intrinsic value is determined independent of where the market is
pricing the security
key factor to intrinsic value is a forecast of a firms earning
power should provide a margin of safety
John Burr Williams (The Theory of Investment Value, 1938)
Intrinsic value of a share of common stock can be found by
discounting all of the future dividends per share DDMs
Provide framework needed to value a stock to a rational investor
Frenzies, e.g. Nifty Fifty craze, New Economy bubbles
Modern Portfolio Theory (MPT) risk & return + growth prospects
Basis for All Valuation Approaches

The use of valuation models in investment decisions (i.e., in decisions

on which assets are under-valued or over-valued) are based on:
A perception that markets are inefficient, and make mistakes in
assessing value
An assumption about how and when these inefficiencies will be
In an efficient market, the market price is the best estimate of value.
The purpose of any valuation model is then the justification of this
Market prices reflect the expectations of investors about the future
prospects. An analyst may wish to infer what expectations about a
companys future is consistent with the current market price.

Justifications for doing the valuation exercise

Uses of Valuation Models

Selecting Stocks
Inferring Market Expectations
Evaluating Corporate Events (M&A, divestitures, spin-offs,
mgt buy-outs
Rendering Fairness Opinions
Evaluating Business Strategies
Shareholder Communication
Private Business Valuation

Analysts use valuation models for a wide number of purposes.

Valuation and Portfolio Management

Valuation part of overall portfolio management process.

Actual portfolio mgt process involves planning, execution, and feedback
Valuation plays a part in the planning and execution steps
Planning includes generating an investment strategy one part of
which is security selection
An investor plans his investments by defining the investment objectives,
constraints and strategy for selecting securities based on valuation
parameters or techniques.
Not all investment strategies require valuations an index fund does
not need to value each stock in its portfolio as the portfolio replicates
the index.
Active investment management strategies: translating expectations into
value estimates to rank securities according to relative attractiveness.
Valuation guides implementation of an investment plan in
determining which security to buy or to avoid 10
Excess Risk-Adjusted Return (Alpha)

The goal of active management : to outperform the benchmark to

produce an excess risk-adjusted return (Alpha)
Alpha to be captured through superior valuations
Any perceived mispricing between the value the manager has placed
on an asset and the markets price is an opportunity, assuming the
manager is correct and the market is wrong.
Expected Holding Period Return = (Expected Capital Appreciation +
Investment Income) / Initial Purchase Price
Actual Holding Period Return = (Actual Capital Appreciation +
Investment Income) / Initial Purchase Price
Ex Ante Alpha = Expected Holding Period Return Required Return
Ex Post Alpha = Actual Holding Period Return Historical Return on
Similar Assets

Alpha can be very different on ex ante and ex post basis

Return Concepts
Discount Rate
Internal Rate of Return (IRR)
Required Return Estimate = Year-ahead dividend /Market
Price + Expected dividend growth rate Dt-1/P + g

The Equity Risk Premium

The Required Return on Equity
CAPM E(R) = Rf + (Rm- Rf)
Fama-French Models
Pastor-Stambaugh model (PSM)
Macroeconomic and Statistical Multifactor Models BIRR
Build-up approach for private Business Valuation
Bond Yield Plus Risk Premium

Country Spread model

The Cost of Equity: Competing Models
Model Expected Return Inputs Needed
Multi E(R) = Rf + j=1,,N j (Rj- Rf) Riskfree Rate; Macro factors
factor Betas relative to macro factors
Macro economic risk premiums
The Fama-French Model
E(Rj) = Rf + jmkt RMRF + j
size RSMB + j
value HML
where RMRF = (RM- Rf)

The Pastor-Stambaugh Model

E(Rj) = Rf + jmkt RMRF + jsize RSMB + j
value HML + j
liq LIQ

Build-up Method
Rj = Rf + Equity Risk Premium + Size Premium + Company Specific Premium

Bond Yield Plus Risk Premium

Rj = YTM on the company long-term debt + Risk Premium
Steps in the Valuation Process
Step 1: Understand the Companys Business
Assess the attractiveness of the industry in which the firm competes
size & growth of the industry, supply relative to demand, recent
developments, and qualitative factors
Determine the firms relative competitive position within the industries it
competes assessment of the firms competitive strategy (cost
leadership, differentiation or focus ??)
Assess the competency of management (can mgt execute its plan?)
Step 2: Forecast the Companys Performance
Top-down Approach (Macroeconomic Industry Individual Company)
Bottom-Up Approach
Industry Analysis + Competitive/corporate Strategies integrated with
financial statement analysis forecasts of sales, earnings, CFs, etc
Quality of earnings (Financial Shenanigans Howard Schilit)

Steps in the Valuation Process
Step 3: Select which Valuation Model to use
Absolute Valuation Models
Generate an intrinsic value
present value analysis (fundamental approach to valuation)
DCF Models on Dividends, FCFF, FCFE, Residual Incomes
Relative Valuation Models
relate an assets value relative to that of another asset
P/E, P/B, P/S, P/CF, Enterprise/EBITDA, P/Div
Role of ownership perspective in Valuation (control premiums)
Marketability and Liquidity Discounts

Steps in the Valuation Process
Step 4: Complete the Valuation
Converting the forecasts into a valuation
A well-accomplished analyst will:
help clients achieve their investment objectives
contribute to well-functioning markets, as their analysis of
companies will lead asset prices toward their true values
benefit shareholders by reporting on mgts performance
Analysts Independence and Objectivity
Step 5: Make the Recommendation
Conveying of opinion via a Research Report
A report should cover three broad areas:
A description of the company, including sales, earnings, products,
industry details, and the macroeconomic overview
Industry and company analyses and forecasts
The valuation and recommendation 16
The Top-Down Analytical Framework
Examines the influence of the
(1) Analysis of Economy general economy on all
companies / assets and the
assets /security markets

(2) Analysis of Industries Analyses the prospects of the

industry, given the outlook of the
economic environment

(3) Analysis of
Analyses the prospects of the
Individual company/asset within the context of
Company / the economic outlook, the prospects
Asset of the industry and company/asset-
specific factors.

Business Cycles

The transition points across cycles are called

peaks and troughs
A peak is the transition from the end of
an expansion to the start of a contraction
A trough occurs at the bottom of a
recession just as the economy enters a
Cyclical Indicators
Indexes of Economic Indicators
Why understand the Industry?
A companys profitability is closely
related to industry it is in.

The fortunes of a company are closely intertwined

with those of the industry in which it operates.
It is unusual for a firm to do well in a troubled
The steel industry in the US collapsed as lower cost
producers in Japan and Korea gained global market
Many US companies went bankrupt and even the
dominant US steel-maker, US Steel suffered losses
for several years.

Prospects of companies are closely related to

the industry that they are in. 21
What is Industry Analysis?

Industry analysis involves the evaluation of an

industrys overall profitability.
The main factors that affect an industrys profitability
Differing sensitivity to the business cycle
Position in the industry life cycle
External Factors
Level of competition within the industry

Industry analysis is the evaluation of factors that affect an

industrys profitability
Effects of Business Cycles on
Growth Industries achieve above-average growth in
sales and profits, independent of business cycle
tend to possesses new technologies and/or produce new

Defensive Industries have stable performance

throughout the business cycle
usually in mature stage, whose product demand is stable
eg. Utilities, consumer nondurables (food, drugs), govt

Cyclical Industries where profitability tracks the

business cycle.
products are discretionary, i.e. consumption moves in line
with economic optimism, eg. automobiles 23
A Stylized Depiction of the
Business Cycle
Sector Rotation
Portfolio is adjusted by selecting companies that
should perform well for the stage of the
business cycle
Peaks natural resource extraction firms
Contraction defensive industries such as
pharmaceuticals and food
Trough capital goods industries
Expansion cyclical industries such as
consumer durables
Sector Rotation
Industry Life Cycles

Stage Sales Growth

Start-up Rapid & Increasing
Consolidation Stable
Maturity Slowing
Relative Decline Minimal or Negative
The Industry Life Cycle
Industry Structure and

Threat of entry
Rivalry between existing competitors
Pressure from substitute products
Bargaining power of buyers
Bargaining power of suppliers
Forces Driving Industry Competition
(Porters Analysis)
Threat of New
Bargaining Power
of Suppliers The Industry
Suppliers Buyers

Rivalry among
Bargaining Power
Existing Firms of Customers
Threat of Substitute
Products or Services

Ease of Entry and Exit
New entrants to an industry (enticed by high price/profit)
puts pressure on price and profits.
Competitive pressure will be greater if its more difficult for
firms to leave
Barriers to entry can be a determinant of industry
Barriers to entry include:
Large capital requirements
Established distribution network that is difficult to duplicate
Strong brand loyalty
Proprietary knowledge or patents/products
High switching cost
Government policy

Barriers to entry can determine industry profitability.

Rivalry among Existing Firms
With several competitors, there will be more price
competition as competitors seek to expand their market
Factors that contribute to this competition include:
Number of competitors
Relative strength of competitors
Slow industry growth
High fixed cost structure high break-even point
Perishable products or high storage costs
Homogeneous products
Switching costs
high exit barriers

Slow growth, a high fixed cost structure and homogeneous

product lead to a high level of competition.
Threat of Substitute Products

Substitute products means that the industry faces

competition from companies in related industries.
Sugar producers compete against corn syrup producers
Cotton and wool producers from synthetic fibre producers
Cinema from other forms of entertainment.
Availability of substitutes limits the prices that can be
charged to customers.

Industry profitability can be affected by availability of

substitute products.
Bargaining Power of Buyers

If a single buyer purchases a large fraction of an industrys

output, it has considerable bargaining power and demand
lower prices.
Car manufacturers can put pressure on suppliers of auto-
Larger retailers can put pressure on supplier as they
purchase in bulk.
Suppliers to one or a small number of buyers are
vulnerable to pressures from buyers and suffer from
reduced profitability.

Suppliers suffer reduced profitability if sales are

limited to a few buyers. 34
Bargaining Power of Suppliers

If a supplier of a key input has a monopolistic control over

that product, it can demand higher profits and squeeze
profits out of the industry.

Microsofts operating system dominance over the personal
A powerful labour union through wage bargaining can
significantly affect an industrys profitability.

Cost of industry input factors affect industry profitability.

We need to understand the industry a company is in. Its profitability is
closely related to the general profitability of the industry.
An industrys profitability fluctuates from year to year.
An industrys profitability is affected by the:
Sensitivity to the business cycle
Stage of the industrys life cycle
Level of competition within the industry
Necessities are not sensitive to the business cycle.
An industry goes through various stages of growth.
An industrys profitability is also determined by the level of competition:
threat of entry
rivalry within the industry
availability of substitutes
bargaining power of suppliers and buyers.
Having analysed suitable industries for investment, the next task is to pick
companies within the industry for consideration.
Competitive Advantage

Competitive positioning determines a firms profitability will be

above or below the industry average
Above-average profitability requires that a firm have a
sustainable competitive advantage
Generic Strategies:
Become the Low-Cost Producer (large scale economies of
scale, vigorous cost control, proprietary technology)

Product Differentiation (the product performs better, looks

better, or is serviced better can raise switching costs by
building customer loyalty)

Focusing on a Special Niche (select an industry segment

satisfying the special needs of those customers)