Equity Investments I

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Equity Investments-I
Agenda
Equity Valuation: Application and Processes
Return Concepts
Neev Knowledge Management Pristine
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Intrinsic Value
Intrinsic Value is an estimate by an analyst of the true worth of the security or an asset. It combines
an estimate of the future expected returns from the asset with an appropriate valuation model to arrive
at the worth of the security.
The market price might significantly diverge from the intrinsic worth of the security. So the analyst
looks for a market or corporate event which will be a catalyst for the divergence to disappear.
The analyst is searching for abnormal returns or alpha which justifies his or her effort in analyzing the
security.
This is known as the rational efficient market formulation which recognizes that a rational investor will
not incur the expense to analyze a security unless he is expected to get a higher reward for his
efforts.
While using active portfolio management, one hopes to discover a positive alpha. This can be done by
searching for security mispricing.
VE P (V P) (VE V )
Where, VE is the analysts estimate of the securitys intrinsic value
P is the current market price of the security
V is the actual intrinsic value of the security.
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Estimates Of Value
Going-concern value
All our valuation efforts as an analyst will focus on companies that are expected to continue operating in
the future.
The company will continue its business activities and will always use its assets in an economically optimal
way to obtain profits.
Going concern assumption is simply the assumption that a company will continue to operate as a
business. The valuation model are all based on the going concern assumption.
Liquidation Value
Here we assume that the company is expected to wind-up its operations and liquidate its assets in the
near future.
Concepts like orderly liquidation in which the non-perishable inventory can be sold during a longer period
of time are also introduced.
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Estimates Of Value
Fair Market Value
The price at which an asset or a liability will change hands between a buyer and a seller when
both the parties are mutually willing parties with no force involved in the deal is known as the
fair market value.
This is often used in valuation related to assessing taxes.
A related concept is used in financial reporting for the purpose of impairment testing.
Investment Value
This concept includes the potential synergies based on the investors requirements and
expectations
It is very important for the right valuation of an organization.
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Applications Of Equity Valuation

Stock Selection
Try to determine whether the security is fairly priced, over priced or underpriced relative to its estimated
intrinsic value and relative to its peer group
Market Expectation Extraction

To determine whether the expectations of a companys future performance is correctly factored into the
current market price of the stock.
Corporate Events Evaluation

To determine the impact of corporate events such as Mergers, Acquisitions, Divestures, Spin-offs, and
Leveraged Buyouts.
Fairness Opinions
A party involved in a corporate event may require a fairness opinion from a third party regarding the terms
of that corporate event.
Business Strategy and Model Evaluation

Used to check whether a business strategy maximizes shareholder value
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Applications Of Equity Valuation

Performance Communication
Discussion among the companys management, shareholders, and analysts can be facilitated with the
help of valuation concepts.
Private Business Appraisals

As there is no current market price, equity valuation is important for transactional purposes, tax reporting,
and IPOs.
Share-base compensation for executives:
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Imp
Alpha
Two Types of Alpha
Ex ante Alpha
= expected return - required return
Ex post Alpha
= historical holding period historical return on similar assets
Following is the analysis report for Yes Bank Stock based on CAPM
Yes Bank : Expected Return: 15%, Actual Return: 16%, Beta = 2, risk premium: 3%, Rf = 6%
Dena Bank Share with Beta = 2, historical returns 15 %
HDFC Bank Share with Beta = 1.02, historical returns 11 %
ICICI Bank Share with Beta = 3.02, historical returns 19 %
Calculate ex ante Alpha ?

Calculate ex post Alpha ?
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Calculating Alpha (Solution)

Ex ante Alpha
= Expected return - required return
Required return = Rf + B(Rm Rf) = 12%
= 15 -12 = 3%
Ex post Alpha
= Historical holding period historical return on similar assets
Dena Bank is similar asset
= 16 15 = 1%
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Steps In Equity Valuation

Valuation involves five important steps :
Understanding the business
Forecasting the company performance
Selecting the appropriate valuation model
Converting forecasts to a valuation

Applying the valuation conclusions
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Imp
Understanding A Business
Industry structure can be analyzed through the use of Porters five forces
Intra-industry rivalry
New entrants
Substitutes
Supplier Power
Buyer Power
A company can gain a relative advantage through the use of three generic corporate strategies
Cost Leadership
The lowest cost producer for products that are comparable to the products offered by other companies.
Differentiation
Offering products or services with additional features to command a premium over similar products offered by
other companies
Focus
Using either cost leadership or differentiation within specific target segments.
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Forecasting Company Performance

Analyzing the companys financial statement is a rich source of information for forecasting future
company performance.
Other sources of information are
Regulator mandated disclosures

Regulatory filings
Company press releases
Investor relations material
Analyst calls
The term quality of earnings analysis broadly includes the scrutiny of all financial statements to
evaluate the sustainability of a companys performance and how accurately it reflects the economic
reality.
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Quality Of Earnings Indicators: Revenues And Gains

Accelerated revenue recognition is often used to hide a declining performance
Bill-and-hold policy for sales recognition.
Recording of sales prior to shipment or recording sales of software prior to installation at the customers
location.
Classification of non-operating income as part of operations

Non-recurring revenue may not come from day-to-day business activities
Note : Link this concept which is already covered in FSA.
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Quality Of Earnings Indicators: Expenses And Losses

Recognizing too much or too little reserves
Restructuring reserves
Loan-loss or bad-debt reserves
Valuation allowances against DTA
Deferral of expenses by capitalizing it as an asset

Aggressive estimates and assumptions
Asset impairment
Long depreciable lives
Long periods of amortizations
High assumed discount rates
Low assumed rate of compensation growth for pension liabilities
High expected Return on Assets.
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Quality Of Earnings Indicators: Other Issues

Balance sheet issues
Use of off-balance sheet financing, such as leasing assets or securitizing receivables
Operating cash flows

CFO is artificially inflated through an increase in bank overdrafts
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Valuation Models
Absolute Valuation Model :
Present Value Models
Dividend Discount models

Free Cash Flow To Equity models
Free Cash Flow to Firm models
Residual Income models
Asset-based Value Models
Relative Valuation Models :

Relative valuation models are typically implemented using
Price multiples
Ratio of stock prices to fundamental values such as cash flows or earnings
Enterprise multiples
Ratios of total value of a common stock and debt net of cash and short-term investments to companys operating
assets
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Issues In Model Selection

Selection of a model should be consistent with the characteristics of the company.
The model should be selected based on the following criteria

Consistency with the characteristics of the company
Appropriateness w.r.t. the given availability and quality of the data
Consistency with the purpose of valuation
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Case Study#1
Rayon Pharmas stock fell drastically after the FDA declined to approve further testing of its new drug.
The new drug was supposed to provide relief to patients suffering from renal disorders. Market
sentiments were very weak and the stock fell drastically from $35 to $20. The market price of $35 was
based on forecasted earnings after the drug would be introduced into the market. Discuss the markets
reaction to the event.
Solution#
The price of $35 is based on the companys estimated earnings through the sale of the new drug.
The company does not have any other drug in the pipeline.
As such the stock price is based on sentiments and the assumption that the drug would be successful and
the company will be able to meet its earning estimates.
The loss in earnings due to the FDA ruling reduces the market price by $15.
If the price recovered after Rayon Pharma released a press release that they were contesting the
FDA ruling with some new data that was omitted when the original application was made. What is its
implications.
Solution#
The price of the stock is driven by sentiments in the market. The market price may significantly diverge
from its intrinsic value and the stock might be placed on a downgrade watch.
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Case Study#2
Lukas Haas has recently joined Alpha Securities as an analyst. He decides to use the dividend
discount model to value Alpha Chemicals, a company that produces industrial paints. Baar Chemicals
has shown steady growth for the past five years. The company has also maintained a steady dividend
of $5 for the last 20 quarters. Stephen Miles is another analyst with Alpha securities he performs a
relative valuation of Baar chemicals and based on its intrinsic value he concludes that the stock is
undervalued. Discuss the approach adopted by Lukas in evaluating Baar chemicals. Also discuss
whether Stephen Miles is correct in his evaluation.
Solution#
The DDM is used when the target company follows a steady dividend policy.
In the above example the company is showing steady growth for the past five years however the
dividends do not show any relation to the companys earnings.
The DDM would not be appropriate in this case.
Solution#
Since Stephen is conducting a relative valuation he should value the company on the basis of a price multiple or
enterprise value multiple.
However he compares the intrinsic value of the stock to arrive at the conclusion that it is undervalued.
The intrinsic value is generally used in absolute valuation methods.
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Agenda
Equity Valuation: Application and Processes
Return Concepts
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Return Concepts
Holding period return is the return earned from investing in an asset over a specified time period.
r
D ( h) P ( h) 1
P(0)
D(h) P(h) P(0)
Dividend Yield Price Appreciation Return

P(0)
P(0)
There are two types of holding period returns:

Realized holding period return
This returns measure is for time periods in the past where all the prices and dividends are known.
Expected holding period return

This returns measure is for time periods in the future where prices and dividends are random variables and
not known with certainty.
Required rate of return is the minimum level of expected returns an investor requires in order to invest
in the asset over a specified time period.
Expected alpha = E(R) Required return
Realized alpha = Actual holding period return Contemporaneous required return
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Return Concepts
Expected returns on a convergence basis
E ( R ) r
V (0) P(0)
P(0)
Discount rate is a term used for any rate that can be used in finding the present value of a series of
future cash flows.
Internal Rate of Return (IRR) is that discount rate that equates the present value of the assets
expected future cash flow to the assets price.
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Equity Risk Premium

The Equity Risk Premium (ERP) is the incremental return that an investor requires for investing in
equities over a risk-free asset like a treasury security.
Required Rate of Return on equity = Current expected risk-free return + ERP
ERP can be estimated using either of the two approach
Historical estimation
Equity Risk Premium = historical mean return for a broad-based equity market index risk free rate
If investors are rational, then the historical estimates are unbiased.
Assumption Mean and Variance of returns are constant over time.
This is not true in the real world, and ERP tends to be countercyclical.
ERP tends to be upward biased due to survivorship bias.
Depends on the method of calculation the ERP derived from geometric means are lower than those derived
from arithmetic means.
Forward-looking approach estimation
Based on current information and future expectations

The mean and variance are not assumed to be constant
Not subject to survivorship bias.
The three main categories of ERP determined by Forward-looking approach estimation:
Gordon Growth Model, Supply-side models, and estimates from surveys.
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ERP From The Gordon Growth Model

More applicable to developed economies and markets due to the availability of dividend payment and
growth rate data.
D1
g rLT ,0
P
Drawbacks:
Forward-looking estimates will change over time
During a boom period, growth rates are high and dividend yields are low
During a bust period, the opposite is generally true.
Model not appropriate for countries where growth rates are not stable
Growth rates in rapidly growing economies fluctuate from time to time
Equity Index Price = PVrapid(r)+ PVtransition(r)+ PVmature(r)
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ERP From Supply-side Models
Equity Risk Premium [1 i] [1 rE g] [1 PE g ] 1 Y R f

Where,
is the expected inflation ( =YTM of 20 year T-bonds YTM of 20 year TIPS)
rg is the expected real GDP = growth in labor productivity + growth in labor supply
Pg is the expected changes in the P/E ratio (positive if current prices are undervalued)
is the expected yield on the index
Rf is the expected risk free rate
Weakness
Appropriate for developed countries where it is reasonable to believe there is a relationship
between macroeconomic variables and asset prices.
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ERP From Survey Estimates

Here, the equity risk premium is calculated by taking the average of a sample of people in the
industry.
This estimate tends to be more accurate when the sample consists of people who are experts in
equity valuation.
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Estimating The Required Rate Of Return

Capital Asset Pricing Model
Required return on sharei = Current expected risk-free return + i *( Equity Risk Premium)
or
Ri R f i ( Rm R f )
Where, i
Cov (i, m)
m2
Multifactor models
The general equation for a multifactor model is:
r = RF + (Risk Premium)1 + (Risk Premium)2 +.+ (Risk Premium)K
Here, (Risk Premium)1 = (Factor Sensitivity) x (Factor Risk Premium)
Factor Sensitivity is the assets sensitivity to a particular factor
Factor Risk Premium for the ith factor is the expected return over the risk-free rate accruing to an
asset with units sensitive to the ith factor and zero sensitivity to all other factors.
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Estimating The Required Rate Of Return
The Fama-French Model (FFM)

Developed to address the short-comings of the CAPM model
ri = RF + imktRMRF + isizeSMB + ivalueHML
Where,
RMRF = Rm-Rf (Same as that in CAPM)
SMB = The average return on 3-small cap portfolios The average return on 3-large cap
portfolios
HML = The average return on 2-high book to market portfolios The average return on 2-low
book to market portfolios
The Pastor-Stambaugh Model (PSM)

An extension to the FFM Model
ri = RF + imktRMRF + isizeSMB + ivalueHML + iliqLIQ
LIQ = Returns of Low-liquidity Stocks Returns of Highly Liquid Stocks
This model incorporates the premium demanded by investors to hold illiquid securities.
On average, the liquidity beta = 0
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Multifactor Models
Models for calculating the required return can be based on macro-economic and statistical factors
Macro-economic models factor in the economic variables that have an impact on future cash flows or on
the discount rates
Statistical factor models utilize statistical methods to historical returns to determine a portfolio of securities
that can explain these returns
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Five Factors Of Multifactor Models

Burmeister, Roll and Ross (BIRR) model is a macro-economic factor model, the five important factors
which effect the multifactor model.
Confidence Risk
The unexpected change in the difference of returns between the 20 year risky corporate bond and the 20
year Government bond.
Time Horizon Risk

The unexpected change in the difference of the returns between the 20 year T-bonds and the 30 day T-Bill.
Inflation Risk
The unexpected change in the inflation rate
Business Cycle Risk

The unexpected change in the level of real business activity
Market Timing Risk

The portion of the return unexplained by the other four risk factors.
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Build-up Method Private Business Valuation
ri = Risk-free rate + ERP + Size Premiumi + Specific-Company Premiumi
Build up models are used for companies that are closely held and betas are not readily available
In the build-up method, the required rate is built up rather than adjusting for different premia.
Other Considerations
The relative values of controlling vs minority interests

Effects due to the lack of liquidity constraints as this company is unlisted thus not traded.
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Build-up Method - Bond Yield Plus Risk Premium
BYPRP cost of equity = YTM on the companys long-term debt + Risk premium
YTM of the companys Long-Term Debt is composed of:
Real Interest Rate

Inflation
Default Risk Premium
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Methods To Determine Required Return - Strengths And

Weaknesses
CAPM
Advantages
Disadvantage
Simple Uses only one factor
Stocks Beta changes according to the index its

measured against
Low explanatory power
Multi-Factor Models
Advantages
Disadvantage
Usually have higher explanatory power than

CAPM
Can be possible that explanatory power is lower

than CAPM
Complex
Expensive
Build-up Models
Advantages
Disadvantage
Simple
Use historical data which may not be applicable in

the current economic scenario
Applicable to closely held companies

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Beta Estimation For Public Companies
Imp
Beta is calculated by the OLS method by regression stock returns on the market returns.
Beta estimates for a public company are influenced by
Choice of the index used to represent the market portfolio
For US Equities the S&P 500 is generally used, for Indian securities the BSE Sensex or the Nifty is
commonly used.
Length of the data period and frequency of observations:
Usually five years of monthly data (60 observations) is used.
Blume adjustment
Since the valuation is forward looking raw beta has to be adjusted.
The most common adjustment is the Blume adjustment
Adjusted Beta = (2/3)*(Unadjusted Beta) + (1/3)*(1.0)
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Beta Estimation For Thinly Traded Stocks And Nonpublic

Companies
Imp
Step 1
Select a comparable benchmark
Step 2
Estimate the benchmarks Beta
Step 3
Unlived the Benchmarks Beta
1
u
e
1 D E
Step 4
Lever the Beta to reflect the subject companys financial leverage
' 1 D' E ' u
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International Issues In Estimating RoE

The issues that concern analysts estimating the required rate of return on equity are
Exchange rates
Data and model issues in emerging markets
The country spread model for the ERP is as follows

ERP estimate = ERP for developed market + Country Premium
Country Premium = Yield on Emerging Markets Bond Yield on Developed Markets Bond
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Issues In Selecting A Discount Rate Based On Cash Flows

If cash flow to equity is to be discounted then the rate of return on equity is used as a discount
rate.
If the cash flows that are available to all the companys capital providers are to be discounted
then the firms cost of capital is used as the discount rate.
Nominal discount rates should be used with nominal cash flows while real discount rates should
be used with real cash flows.
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Case Study#7
The factor sensitivity and the risk premium for Arizona Mining is as follows
Factor Sensitivity
Risk Premium
Market Beta
1.18
5.45%
Size Beta
-0.70
2.03%
Value Beta
1.22
1.54%
Liquidity Beta
-0.45
0.70%
The risk free rate of return is 4.5%.

Calculate the required return for Arizona Mining based on the PSM model.
Discuss the style characteristics of the company based on its factor sensitivity
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Case Study#7 Solution

The required return based on the PSM model can be calculated as follows
E(R) = 4.5% + 1.18*5.45 0.7*2.03 + 1.22*1.54 0.45*0.7 = 11.07%
The stock is highly correlated with the market. The stock is a large cap stock from the negative
sensitivity to size beta. It is a value stock with high liquidity.
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Case Study#8
The 20-year corporate bond of Arizona Mining has a YTM of 8.54% while the corresponding 20-year
T-bond has a YTM of 5.04%. Calculate the required return on the stock using the bond yield plus risk
premium method given that the risk premium is 3.45%.
Solution#
BYPRP cost of equity = YTM on bond + risk premium = 8.54 + 3.45 = 11.99%
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Extra-Case Study
Nelson Muntz prepares a few questions that will be used to shortlist potential candidates for the position of
an analyst. Hank Azaria, the administrator at his firm, takes printouts of the questions. He makes a few notes
on some questions on the print-out. The first few statements on the paper are as follows
Statement #1: A stock was bought at $22 on Jan 1 2010 and during the year the firm issued dividends worth
$2.5 per share. On 30th Dec 2010 the stock was priced at $27.
Statement #2: Estimate the beta of MNK Corp., a privately held company. The company has a debt-toequity ratio of 40:60. A comparable firm DTBHJ Corp. has a beta of 1.35 with a debt-to-equity of 35:65.
While interviewing the potential candidates Muntz decides to make the proceedings even more interesting.
He asks the candidates to calculate the required rate of return using the FFM-model. The risk-free rate is
4.1%, RMRF is 4.1%, SMB is 2.5% and HML is 2.0%. The respective beta factors are 0.85, 1.14 and 1.2.
He finds that a candidate Ruth Powers looks very promising. He asks her to calculate the WACC for DTBHJ
Corp. The following information is provided
Debt as % of total capital = 35%
Tax rate = 32%
Given beta is 1.35 while the expected return from the market is 10.5% and risk free rate is 4.1%.
The company has also issued long-term debt with YTM of 5.6%
Powers provides the required solution. Muntz is satisfied with the answer and asks her to solve one final
question. He asks her to calculate the required rate of return given the unanticipated change in confidence
risk is 2.5%, time horizon risk is 0.75%, inflation risk is 4.35%, business cycle risk is 1.52% and market
timing risk is 3.71%.
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Extra-case Study- Questions

1. The holding period return for the stock is closest to
A. 34.09%
B. 32.45%
C. 24.25%
2. The beta for MNK Corp. is closest to

A. 1.5714
B. 1.4625
C. 1.3124
3. Given the above information the required return using the Fama-French model is closest to
A. 11.142%
B. 10.345%
C. 12.835%
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Extra-case Study- Questions

4. The WACC for DTBHJ Corp. is closest to
A. 9.8%
B. 9.6%
C. 8.5%
5. Given that the T-bill rate is 7.52% and the sensitivity betas are given as follows
Sensitivity to confidence risk = 2.02
Sensitivity to time horizon risk = 0.95
Sensitivity to inflation risk = -0.84
Sensitivity to business cycle risk = 0.95
Sensitivity to market-timing risk = 1.20
A. 15.52%
B. 14.17%
C. 16.24%
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Solution
1. A.
2. B.
r Dividend Yield Price Appreciation Return

P P 2.5 38 22
D
H H 0
0.1136 0.2273 34.09%

P0
P0
22
22
U
1
1 D
DTBHJ
1
1 35
*1.35 0.8775
65
MNK 1 DMNK E * U 1 40 60 * 0.8775 1.4625

MNK

3. C.
Required Rate of return = 4.1% + 0.85*4.1 +1.14*2.5 + 1.2*2.0 = 12.835%
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Solution
4. B.
Using CAPM the required rate of return = 4.1 + 1.35*(10.5 4.1) = 12.74%
The WACC can be calculated as follows
WACC
WACC =
MV ( Debt )
MV ( Equity )
* rd * (1 t )
* re
MV ( Debt ) MV ( Equity )
MV ( Debt ) MV ( Equity )
0.65 *12.74 0.35 * 5.6 * (1 0.32) 8.281 1.3328 9.6138%
5. A.
The required rate of return = 7.52 + 2.5*2.02 + 0.75*0.95 + 4.35*(-0.84) + 1.52*0.95 + 3.71*1.2
= 15.52%
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Neev Knowledge Management Pristine

Neev Knowledge Management Pristine

Neev Knowledge Management Pristine

Neev Knowledge Management Pristine

Applications Of Equity Valuation

Market Expectation Extraction

Corporate Events Evaluation

Business Strategy and Model Evaluation

Neev Knowledge Management Pristine

Applications Of Equity Valuation

Private Business Appraisals

Share-base compensation for executives:

Neev Knowledge Management Pristine

Calculate ex ante Alpha ?

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Calculating Alpha (Solution)

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Steps In Equity Valuation

Converting forecasts to a valuation

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Forecasting Company Performance

Regulator mandated disclosures

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Quality Of Earnings Indicators: Revenues And Gains

Classification of non-operating income as part of operations

Note : Link this concept which is already covered in FSA.

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Quality Of Earnings Indicators: Expenses And Losses

Deferral of expenses by capitalizing it as an asset

Note : Link this concept which is already covered in FSA.

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Quality Of Earnings Indicators: Other Issues

Operating cash flows

Note : Link this concept which is already covered in FSA.

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Dividend Discount models

Asset-based Value Models

Relative Valuation Models :

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Issues In Model Selection

The model should be selected based on the following criteria

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D(h) P(h) P(0)

Dividend Yield Price Appreciation Return

There are two types of holding period returns:

Expected holding period return

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Equity Risk Premium

Forward-looking approach estimation

Based on current information and future expectations

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ERP From The Gordon Growth Model

Equity Index Price = PVrapid(r)+ PVtransition(r)+ PVmature(r)

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ERP From Supply-side Models

Equity Risk Premium [1 i] [1 rE g] [1 PE g ] 1 Y R f

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ERP From Survey Estimates

Adjusted Beta = (2/3)(Unadjusted Beta) + (1/3)(1.0)

Required Rate of return = 4.1% + 0.854.1 +1.142.5 + 1.2*2.0 = 12.835%