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Beauty lies in the eyes of the beholder; valuation in those of the buyer
Valuation
Valuation is worth of an asset which can be an equity, bond, a firm etc. To realize benefit of an investment such as return, valuation is must. Business valuation is a process and a set of procedures used to estimate the economic value of an owners interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business Input for valuation varies according to type of asset Business is based on expectations which are dynamic, valuation also tends to be dynamic and not static which means that the same transaction would be valued by the same players at different values at two different times.
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Why Valuation?
CEO/CFO/Operating Mgr Insiders Decision Making Identifying Opportunities
Investment Bankers Consultants Sell side / Buy Side Analyst Credit Analyst
Approaches to valuation
Valuation is based on going concern approach. Determination correct valuation is essential for successful investment . Valuation may change according to type of the firm manufacturer / service provider. Tools available for valuation
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Relative Valuation
Based on market trading multiples of comparable comp Usually focuses on forward looking Profit / EBITDA / Cash Flow
M&A Comparables
Based on multiple paid for comparable comp. assets in sale transaction Focus mainly on multiples of Historical Profit / EBITDA / Cash Flow
Asset Valuation
Based on fair value of individual assets Book Value may not be equal to fair value
Sum of Parts
Divides the business into separate sub-entities (parts) Add the value of each part to find the total value
Book Value
Principles of Valuation
Liquidation Value
Amount that would be raised if all assets were sold independently
Synergy: The Premium for Potential Success For the most part, acquiring companies nearly always pay a substantial premiumon the stock market value of the companies they buy. The justification for doing so nearly always boils down to the notion of synergy. a merger benefits shareholders when a company's post-merger share price increases by the value of potential synergy. it would be highly unlikely for rational owners to sell if they would benefit more by not selling. That means buyers will need to pay a premium if they hope to acquire the company, regardless of what pre-merger valuation tells them. For sellers, that premium represents their company's future prospects. For buyers, the premium represents part of the post-merger synergy they expect can be achieved. The following equation offers a good way to think about synergy and how to determine whether a deal makes sense.
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Synergy
Enterprise Value
Market Cap + Total Debt Total Cash & Short Term Investments EV is a measure of theoretical takeover price, and is useful in comparisons against income statement line items above the interest expense/income lines such as revenue and EBITDA. Commonly adopted valuation model = EV/EBITDA
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Cost of acquisitions
Payment to equity share holders (No. of equity shares x MP of equity share) + payment of preference hare holders + Payment to debenture holders + payment of other external liabilities ( creditors etc) + Obligations assumed to be paid in future (pension etc) + Dissolution expenses + Unrecorded / contingent liabilities (LC/BG) - Cash proceeds from sale of assets of target firm.
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Approaches to valuation
Income approach
Market approach
Asset approach.
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13
300 200 89 1 00 1 7 0 2008 2009 201 0 201 1 201 2 201 3 201 4 201 5 201 6 24 24 31 53 1 02 10 1
Terminal Value
A nnual cashflo w
Terminal Value
where CFt is the cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and t is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate.
CFt V t 1 t 1 r
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Equity valuation
The value of equity is obtained by discounting expected cashflows to equity, i.e., the residual cashflows after meeting all expenses, tax obligations and interest and principal payments, at the cost of equity, i.e., the rate of return required by equity investors in the firm. where, CF to Equityt = Expected Cashflow to Equity in period t ke = Cost of Equity The dividend discount model is a specialized case of equity valuation, and the value of a stock is the present value of expected future dividends. Value of Equity =
CFt V t 1 t 1 ke
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Firm valuation
The value of the firm is obtained by discounting expected cash flows to the firm, i.e., the residual cash flows after meeting all operating expenses and taxes, but prior to debt payments, at the weighted average cost of capital, which is the cost of the different components of financing used by the firm, weighted by their market value proportions.
where, CF to Firmt = Expected Cashflow to Firm in period t WACC = Weighted Average Cost of Capital
CFtoFirm V t 1 t 1 WACC
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Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) The current market value of equity is $1,073 and the value of debt outstanding is $800. Source Aswadh Damodaran 21
Approach to valuation market approach It is used when valuing a private firm. Value under market approach is determined based on prices that have been for similar assets in the market . How an exactly similar firm ( in terms of risk, sales, growth and cash flow ) is priced. It is more realistic since it measures relative market value rather than intrinsic value.
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Value of firm comparable firm approach The comparable company method uses valuation multiples that are derived from observed stock market prices of comparable publicly traded firms When the target firm's stock is not publicly traded, an estimate of its market price can be constructed using the market prices of comparable firms in the same industry Estimates are usually based on performance measures such as the priceto-cash-flow-per-share ratio or price-tobook-value ratio, Beta factor etc
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Value of firm comparable firm approach ABC company has sales RE 200 crore ,MV/EBDITA@ 14 & MV/FCF@ 10. An investor wants to acquire this company based some variables EV/Sales, MV/EBDITA & MV/FCF, PAT, etc He wants to give 50% weight age to earnings in the valuation process. He has identified 3 comparable firms.
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EV/Sales
1.4
1.1 15.0
1.1 19.0
MV/EBDITA 17.0
MV/FCF
20
26
26
30
average
1.4
17.0 20
1.1
15.0 26
1.1
19.0 26
1.2
17.0 24.0
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MV/EBDITA
MV/FCF
200 14 10
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Value of firm comparable firm approach Weighted average will be { 240x1) + (238 x2) + (240x1)}/4 = Re 318 cr Value of ABC = Re 239 cr.
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Approach to Valuations- Asset approach It involves two measurements viz Adjusted Book value and Liquidation method. Adjusted Book value method assumption based on going concern method and accordingly assets are valued . Liquidation method assumption is based on business will cease and liquidation will occur. Realizable value cost of realization.
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WC as % of revenue
Tax rate Capital expenditure are off set by depreciation
25%
36%
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Free cash flow to the firm = EBIT(1-t)+depreciation and amortization capital expenditure change in working capital
220
141
152
160
165
38 184
Revenues 7000
7350 7720
8100
8510
8930
Working capital
1750
1840 1930
2025
2130
2230
Change in WC
90
90
95
105
100
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Yr
FCFF
Debt
Int.(1-t)
1 2 3 4 5 6
(12,00,000) 4,00,000 Equity 8 + debt 4) 80,000 20,480 1,04,000 20480 1,35,200 20,480 1,75,760 20,480 3,07,580 20,480 5,38,265 20,480
(8,00,000)
Cost of capital
WACC kd(1-t)BV+kp P/V+ Ke S/V Ke = cost of equity Kd = cost of debt T = marginal tax rate B = Market value of interest bearing debt V =market value of enterprise being valued ( V=B+P+S) P = Market value of preference shares S = Market value of equity
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Weighted average cost of capital Proportion of Equity @50 ,Preference @10 & Debt 40%. Cost Equity @ 16, Preference @ 12 & Debt @ 8% WACC = (0.5)(16)+(0.10)(12)+(0.4) (80) = 12.4% WACC =kd(1-T)B/V+kpP/V+KeS/V
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Cost of equity
Cost of equity is the expected return by investors. There 2 methods CAPM Arbitrage Pricing Model.
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CAPM
Securities are risky since returns are variable SD measures the variance Risk of security arises from market and unique risk Portfolio diversification can eliminate unique but not market risk Contribution of a security to the portfolio risk is measured by beta
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CAPM
Assumptions All investors aim to maximize their returns All operate on common single period planning horizon All are rational and always look at risk and return All investors are price takers, i.e. no investor can influence market price by his scale of operations Dividends and capital gains are taxed at the same rate. All securities are highly divisible i.e. can be traded in small parcels
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CAPM
CAPM is an equilibrium model which describes the pricing of assets, as well as derivatives. Expected return of an asset equals the risk less return + risk premium. Expected security return= Risk less return + beta x (expected risk premium) In short, CAPM describes relationship between risk and expected return and that is used in the pricing of risky securities. Beta is used to measure additional risk (systematic) faced by the investor.
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Systemic risk and un systemic factor in portfolio of investments. investors expectations - Higher the risk higher the return. Beta factor - each has company has a beta factor. A companys beta factor is that companys risk compared to the risk of over all market. If a company has a beta factor of 3.0 , it is said to be 3 times more risky than the over all market. Investor investing in such company , expectation of return will be higher. Market risk premium or the price of taking risk is the difference between the expected rate of return in the market and risk free rate. Market risk premium is based on the past or future.
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CAPM
Market risk premium- Historical Period Approach. Simple of estimating premium based on difference between actual returns on stock over along period and return on risk free asset. Problems 1. length of the period 2. choice of risk free security T-Bill/G-Sec. 3. arithmetic and geometric averages.- each one has its own pros and cons. Arithmetic measures average of the annual returns for the chosen period and geometric measures compounded values. But market risk premium lies in between 53 two.
Determination of Beta.
Beta is influenced by 3 factors 1.type of business- expected to be in cyclical industry such as steel, real estate etc. 2.degree of OL (contribution/EBIT) Indicates fixed operating cost. Lower the better. 3.degree of FL ( EBIT/EBT) indicates fixed financial cost . Lower the better. What is FL of Infosys ? Economic conditions Inflation/Deflation. FMCG verus Pharma. Increase in OL/FL shall increase the Beta of the company.
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>1
B A B A
B
C
<1
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Rf=10
05
1.0 Beta
1.5
2.0
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CAPM
Model that links the notions of risk and return Normally government securities are taken as risk free scurrilities and its rate as risk free rate. Historical premium earned by a equity market index over and above risk free rate is used to estimate the expected return on the market. Cost of equity thus obtained is used as discount rate for cash flows. Helps investors define the required return on an investment As beta increases, the required return for a given investment increases
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Beta versus risk premium XYZ co is a private operating in textile industry. D/E- 0.2.Tax rate @ 36%. Estimate the Beta if D/E goes up to 0.23. Information on other firms in textile industry Firm A B Beta 1.10 1.22 D/E 0.24 0.33
C
d
1.35
1.20
0.22
0.20
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Arbitrage Pricing Model (APM) CAPM measures only one variable i.e. risk free and market return. APM measures security return with other variables such as Industrial production index to show strength of the economy Short and long term interest rate vis--vis inflation rtc Empirical studies suggest that that APM explains expected returns better than single factor CAPM. Default risk between yield to maturity on aa & bb rated long term bonds APM cost of equity can be measured by Ke = Rf + [ E(F1) Rf ] 1 +[E(F2) Rf ] + +[E (Fk) - Rf] k E(F1) = Expected rate of return on a portfolio that resembles the kth factor independent of all other factors. k = sensitivity of the stock return to the kth factor.
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Arbitrage Pricing Model (APM) T- bill trades @ 4.5%. Assume 3 different factors are considered. Estimate the cost of equity
Factor 1 Factor 2 Factor 3
Risk 4% premium
4.5%
3%
Beta
1.25
0.95
1.15
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Cost of equity = 4.5% + (1.25 x4%) + (0.95 x 4.5%) + (1.5 x 3%) = 4.5 + 5 + 4.275 + 3.45 = 17.225%
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Terminal value or continuing value A companys can be separated in to 2 periods i.e. cash flow (PV) during explicit forecast period and after explicit forecast period (terminal value) . Value = PV during Explicit period+ PV after explicit forecast period. Value of the firm = V CF + terminal value 1 k -----------------( 1 + kc )^n
n t t 1 t
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Year 1 2 3 4 5 NPV
+ Vn / (1 + Ke,s)^ n
Ct Vn t 1 t 1 R
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Value of equity in 2 stage discount model XYZ ltd is a manufacturer of electronic goods. Reported EPS in March,2005 Re 5.7 and dividend @ Re 2.28. Tax rate@ 40%.T.bill rate@ 7%.Market premium 5% Estimate value of equity using dividend discount model Particulars High growth period 4 years ? 1.3 15% Stable growth
Length of the period Exp. Growth. rate. Beta Ret. on. assets
D/E
DPS
1
40%
1
?
74
8%
8%
= 1 { g/ROA+D/E [ ROA i(1 t)] = 1 { 0.08/0.15 +1[0.15 0.08 (1-0.4) = 1 0.317 = 0.683 or 68.3% Estimation of equity follows
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Year 1
EPS 2
DPS 3
Disc.rate@13.5% 4
PV 5(3/4)
1
2 3 4
6.56
7.55 8.69 10.00
2.6424
3.070 3.477 4.003
1.135
1.288 1.462 1.659
2.311
2.344 2.378 2.411
Ks = Krf + (Km Krf) High growth rate = 7%+1.3(5%) = 13.5% Stable growth rate = 7% +1.15(5%) = 12.75%
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Value of equity in 2 stage discount model Total PV of dividends =Re 9.45 Terminal price = expected dividend per share n+1/(r gn) Expected EPS = 10(1+0.08) = 10.8 Expected DPS = 10.8 x 0.683 = 7.37 Terminal price = 7.37/(0.1275 0.08) =Re 155.15 PV of terminal price 155.15/1.659=93.52 Value of firms equity = 9.45+93.52 = Re 102.97.
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2005 EBIT
- Tax@40% - (Capex)
1314 525.6 76.65
2006 2007
1438.83 575.53 83.93 135.23 1575.52 630.21 91.91 148.08
2008
1725.19 690.07 100.64 162.15
2009
1889.09 755.64 110.20 177.55
Termin al value
1964.65 785.86 114.61 81.86
FCFF
588.25
644.14
540.16
705.32
541.64
772.33
543.13
845.7
544.21
982.32
538.69 PV of FCFF@9.2%
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Estimation of change in WC
REVENUES
13000
14235
15587.33
17068.12
18689.59
20465.10
21283.70
WC
1300
1423.5
1558.73
1706.81
1868.96
2046.51
2128.37
Ch. in. WC
123.5
135.23
148.08
162.15
177.55
81.86
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APV method
Liabilities (Re in lac) Equity ( 4 lac shares of Re 100 each Reserves Amount Assets amount
Hypothetical ltd ( H) wants to acquire Target ltd (T). Balance sheet of T ltd
400
Cash
10
100
Debtors
65
11% Deb.
200
Stock
135
creditors
160
Machinery
650
Total
860
total
860
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APV method
Share holders of T will get 1.5 share in H for every 2 shares. Shares of H is valued at MP of Re180 per share. Debentures holders will get 11% for the same amount External liabilities are expected to be settled at Re 150 lacs. Dissolution expenses @ 15 lacs. To be met by acquiring company. projected FCFF for 6 years.
Year end 1 2 3 4 5 6
APV method
FCFF of T is expected to grow @ 3% after 6 years Cost of capital @ 16% Unrecorded liability Re 20 lacs Advise the company regarding financial feasibility of acquisition. Cost of acquisition if FCFF is likely to grow TV6 = FCFFt (1+g)/(Ku- g) If FCFF is likely to decline FCFFt (1+g)/(Ku +g)
Equity (3,00,000 x 180) 11% debentures External liabilities Un recorded liability Dis.Exp.
Total
925
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APV method
Terminal value TV6= FCFF6(1+g)/ ( Ku Kg) = Re 120 lac (1.03) / (0.16 0.03) = Re 950.77 lac PV of TV = 950.77 x 0.410 = Re 389.82 lac
Yr end FCFF PV@ 16% Total PV
1 2
3 4 5 6 Total
150 200
260 300 220 120
0.862 0.743
0.641 0.552 0.476 0.410
129.30 148.60
166.66 165.60 104.72 49.20 764.08
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Continuing value
Continuing the same example free cash flow of T ltd is expected to grow at 3% after 6 years. Cost of capital decided at 13% (16-3)
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Continuing value
Equity (3,00,000 x 180)
Total
Continuing value
Year end 1 2 3 4 5 6 Total FCFF 150 200 260 300 220 120 PV@13 0.885 0.783 0693 0.613 0.543 0.480 Total PV in Re 132.75 156.60 180.18 183.90 119.46 67.60 830.49
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Continuing value
Tv6 = FCFF6(1+g)/(ko-g) = 120(1.03)/(0.13- 0.03)=Re 123.6/0.1 = Re 1236 lacs PV of FCFF (1-6) Re 830.49 PV of CF after 6 yrs Re 593.28 Less cost of acquisition Re 925.00 NPV Re 498.77 NPV is positive
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Continuing value
Would your decision change, if FCFF after 6 years (forecasted period) assumed to be (a) constant &(b) decline by 10% . TV = FCFF6/ko = 120/0.13 = 923.08 PV = 923.08 x 0.480 = 443.08 PV of FCFF 830.49 PV after 6 years 443.08 Less cost of acquisition 925.00 NPV 348.57
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Continuing value
If decline by 10% TV = FCFF6(1-g)/(ko +g) = Re 108(120 x90) /(0.13+0.10)= 469.57 PV = 469.57 x 0.480 = 223.59 PV of FCFF 830.49 PV after 6 years 225.39 Less cost of acquisition 925.00 NPV 130.88
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Exercise
Banindar software international Revenues - Re 20 lakhs EBIT - Re 2 lakhs Debt Re 10 lakhs Interest (pre tax) Re 1 lakh Book value of equity - Re 10 lakhs (MV is 3 times of BV) Average Beta of publicly traded firms 1.30 Average debt equity 0.2 ( based on market value of equity) Market value of these firms on an average are 3 times of the book value of equity Tax 35% Capital expenditure during the last year Re 1 lakh which is twice the depreciation charge in the last year. Both the items are expected to grow at the same as revenues for the next 5 years and to off set each other in steady state. Revenue growth @ 20% p.a. for next 5 years and 5% p.a. after that. Net income is expected to grow @ 25% p.a. for next 5 years & 5% p.a. after that. T-bill rate (365 days) 5.5% p.a. Return in the market 11% Calculate cost of Equity/cost of capital /FCFF/FCFE
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Exercise solution
Unlevered Beta for firms in the same business. = 1.30(1+0.65 x 0.2) = 1.15. D/E ratio 10/30= 33.33 %(estimated market value of equity) New levered Beta for similar firms = 1.15 x (1+0.65x 0.3333) = 1.40 New cost of equity = 5.5% (1.40 x 5.50%) = 13.20% Pre cost of Debt - 10 % After tax cost of debt = 10% (1-0.35) = 6.5% cost of capital = 6.5% (0.25) + 13.2% (0.75) = 11.53% 97
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FCFF
0.96/1.1153+1.152/1.1153^2+1.389/1.1153^3+1.6575/1.1153^4 + 1.997/1.1153^5 = 0.96/1.1153+1.152/1.70+1.389/2.42+1.6575/3.07+1.997+52.06/3.65 = 0.861+0.678+0.574+0.54+14.81= Re 17.463 lakhs Value of equity = 17.463- 10.00 = 7.463 lakhs
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FCFE
0.75 0.45
0.94 0.54
1.17 0.65
1.46 0.78
1.83 0.93
1.98 0.00
0.30
0.40
0.52
0.69
0.90
1.98
TV
20.41
100
FCFE
TV of equity = 1.98/(0.132-0.05) = Re 24.146 lacs = 0.30/132+0.40/132^2+0.52/132^3+0.69/132^4+0.90+20.41/132^5 = 0.30/132+0.40/1.664+0.52/2.353+0.69/2.962+25.046/3.50 = 0.265+0.240+0.221+0.233+7.156 PV = Re 8.115 lacs
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Value - caution
Not necessarily. Companies can trade on multiples lower than those of their peers for all kinds of reasons. Sure, sometimes it's because the market has yet to spot the company's true value, which means the firm represents a buying opportunity. Other times, however, investors are better off staying away. How often does an investor identify a company that seems really cheap, only to discover that the company and its business is teetering on the verge of collapse? In 1998, when Kmart's share price was downtrodden, it became a favorite of some investors. They couldn't help but think how downright cheap the shares of the retail giant looked against those of higher-valued peers Walmart and Target. Those Kmart investors failed to see that the business's model was fundamentally flawed. The company's earnings continued to fall and, overburdened with debt, Kmart filed for bankruptcy in 2002. Investors need to be cautious of stocks that are proclaimed to be "inexpensive". More often than not, the argument for buying a supposed undervalued stock isn't that the company has a strong balance sheet, excellent products or a competitive advantage. Trouble is, the company might look undervalued because it's trading in an overvalued sector. Or, like Kmart, the company might have intrinsic shortcomings that justify a lower 102 multiple.
Valuations - Caution
It is only future estimate. Based on data which may not happen due to uncertainty. Valuation may be quantitative but based on subjective judgment. Eg. Discount rate. Valuation is time specific. E.g. TATA CORUS deal which has taken place when the market was at its peak. Market value versus estimated value. Under or over valuation. Collective wisdom (market) versus individual wisdom.
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104
THANK YOU
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