Study Session 10 Asset Valuation: Basic Valuation Concepts

Study Session 10 Asset Valuation Basic Valuation Concepts

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Study Session 10 Asset Valuation: Basic Valuation Concepts

Section A. Foreword
a. How are the classic works on stock valuation reflected in modern security analysis? In this section, we provide a brief overview of the two theoretical cornerstones of valuation - investment analysis framework of Graham and Dodd, and Modern Portfolio Theory. We also review some applications of this work to valuation of equities by listing the models to be discussed in later study sessions. Benjamin Graham and David L. Dodd were the pioneers of fundamental analysis of a company's value. They introduced the idea that a company's value may be determined by evaluating its financial statements. John Burr Williams offered the first formal model for this analysis - dividend discount model. He argued that the company's intrinsic value can be estimated as a sum of present values of all expected dividends. Several decades later, Graham and Dodd went further in their analysis of the relationship between the market value of a company and its underlying fundamentals. They distinguished between speculation and investing, stipulating that investment decisions should be based on the analysis of the earning power of a company. According to Graham and Dodd, successful investment strategies fall into two categories: Buying major corporations' stocks around their intrinsic values; Buying other stocks at prices substantially lower than their intrinsic values. In both of these cases, intrinsic value of a stock depends mainly on the company's earning power. Modern Portfolio Theory (MPT) is based on the Markowitz's portfolio selection model and the Capital Asset Pricing Model (CAPM). MPT introduced an entirely new framework for investment decision-making, where both risk and expected return on asset should be taken into account. It recognizes different types of risk - systematic and diversifiable risk. Practitioners may employ MPT to effectively manage portfolios or use it to determine the required rate of return for valuation models.

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Study Session 10 Asset Valuation: Basic Valuation Concepts b. The basic rudiments of dividend discount models, free cash flow models, market multiple models, and residual income models. Dividend Discount Model: Intrinsic value is equal to the sum of present values of future dividends; Future dividends are discounted using the required rate of return on equity; DDM is closely related to the to the P/E multiple justified by fundamentals; The model relates intrinsic value of a stock to the company's growth, provided that certain assumptions hold. Depending on the expected pattern of future growth, single-stage and multistage variations of DDM exist. Free Cash Flow Model: Intrinsic value is equal to the sum of present values of future free cash flows; Several types of FCF models exist, depending on the definition of cash flow - FCFE or FCFF; Depending on the definition of cash flows, they are discounted using the company's required rate of return on equity or weighted average cost of capital; Depending on the expected pattern of future growth in free cash flows, single-stage and multistage variations of FCF model exist. Market Multiples Model: Relative valuation analysis using P/E, P/B, EV/EBITDA and other multiples; Each multiple compares the market value of the company's stock with some underlying fundamental value; A company's actual multiple is compared either to some fundamentally supported value of this ratio, or to its benchmark value (for example, based on the group of peer companies); Certain ratios, called momentum indicators help in determining the company's valuation based on its historical price performance. Residual Income Model: Intrinsic value of a company is equal to the current book value plus the sum of discounted future economic earnings; Economic earnings are essentially accounting earnings adjusted for the cost of capital contributed by the shareholders; The inputs in the model are based on readily available earnings information from companies' financials; Depending on the assumed pattern of future residual earnings, single-stage and multistage variations exist.

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Study Session 10 Asset Valuation: Basic Valuation Concepts

Section B. The Equity Valuation Process

a. Valuation concepts and models. Valuation - determination of an asset's value based on: comparison with similar assets (relative valuation), or fundamentals related to future returns (absolute valuation). Practitioners perform valuation of stocks for the following purposes: Selection of stocks for a portfolio Analysts try to determine the most attractive investments by comparing their estimated intrinsic value with the market price. Value-centric corporate strategizing To maximize the value of shareholders' investment in the company, management should be focused on maximizing the company's value. Obviously, valuation of company and its departments is necessary for strategy planning, tracking results of the past strategies, and determining management compensation. Communication with the market All parties in the investment process: portfolio managers, potential investors, current shareholders, analysts, management of the company, investment banks and investment advisers use valuation as a central point of discussion. Therefore, valuation performs the purpose of information flow and exchange of opinions between all these parties. Understanding implied market expectations Based on their valuation models, analysts can infer expectations implied in the market by making intrinsic value equal to the current market price and solving for underlying fundamentals. After that, analysts can analyze the reasonableness of such expectations and make conclusions regarding the attractiveness of the stock's price, based on forecasted change in market expectations. Analysis of corporate events When a company announces a merger, acquisition, divestiture of some assets, or other corporate event, analysts employ valuation to understand the influence of these events on the intrinsic value of the company (or companies). Sometimes the acquiror asks a third party (an investment bank) for a fairness opinion, which is essentially an independent valuation of the target. Analysis of private companies as potential investments Venture capital funds and private equity investors use valuation as a part of their toolkit for determining the attractiveness of investments in private companies.

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Study Session 10 Asset Valuation: Basic Valuation Concepts The importance of expectations in the use of valuation models If a manager constantly agrees with market's valuation of securities, he or she cannot be consistently profitable in her investment decisions. Only when a deviation of the asset's market price from its underlying (or intrinsic) value is spotted, a strategy exploiting this "mispricing" can be expected to be profitable. On the other hand, if the mispricing is not real, the strategy will not generate profits. Therefore, a manager needs to do both: Produce forecasts differing form the market consensus expectations; Be correct on average in his or her forecasts. Valuation models based on such expectations produce superior estimates of the intrinsic value of an asset. Contrast top-down and bottom-up approaches to equity analysis Depending on the purpose of the analysis, investors use two approaches to linking the company's valuation with general economic conditions: top-down and bottom-up analyses. In a top-down analysis, investor starts with the analysis of national or international macroeconomic conditions, determines their influence on specific industries, and then identifies companies within these industries that are expected to benefit (or rise in value) from these trends. The bottom-up approach, on the other hand, an analyst might start with the forecast of specific companies, infer the influence of these future developments on the industry and even make certain conclusions about the future trends of the general macroeconomic activity. Example of the top-down approach: The interest rate differential between the European Union and the United States is expected to decrease; This supports the forecast for the future depreciation of the euro against the dollar; Aluminum industry in the United States is expected to be the primary victim of the rise in dollar's value; ABC company in the US aluminum industry has the highest share of exports to Europe among its peers and its value is expected to suffer the most. Example of the bottom-up approach: XYZ, YXZ and ZYX investment banks have recently announced major cuts of their workforce; These announcements are a part of a major trend in the entire financial industry, which is expected to persist in the medium term; These developments signal the continuing cost-cutting and downsizing trends in the United States and may result in further stagnation of aggregate demand in the economy.

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Study Session 10 Asset Valuation: Basic Valuation Concepts b. Quantitative and qualitative factors in valuation. Most analysts employ quantitative models of financial analysis and then adjust their forecasts by qualitative factors. We will discuss these quantitative models in detail in further study sessions. The common idea behind all these models is that an analyst can use the company's financial data and reports, as well as its market price, to determine its intrinsic value. The analysis does not stop there, since certain qualitative factors must also be taken into account, such as the quality of the financial statements, the company's new products and management expertise. Although many of these qualitative factors are not quantifiable, they are equally important as determinants of the company's fair value. We have already mentioned that quantitative valuation models can be employed to calculate intrinsic value of a stock. Nevertheless, the results of these calculations are no more accurate than the quality of inputs in the models. Such inputs are drawn from the financial statements and their quality varies significantly across companies. When analysts say quality of financial statements, they mean the degree to which these statements allow to understand financial situation of the company. Combination of early revenue recognition, capitalization of expenses and aggressive estimates of depreciable lives signals low quality of financial statements. Should analysts use this low-quality raw data as inputs in the model, their estimates of intrinsic value of the company's stock will be far from its fair value. Consequently, analysts need to evaluate financial statements with diligence to understand their quality and make necessary adjustments to some items in order to improve the accuracy of intrinsic value estimate. Example Marc Lodd considers valuation of Rubens Motors, a large manufacturing company. After evaluating its financial statements, Marc gathers the following information about the company's accounting practices: Average depreciable life of fixed assets of Rubens Motors is 20.3 years for buildings and 8.0 years for equipment; Industry average depreciable lives are 16.1 years for buildings and 5.2 years for equipment; Fixed assets of Rubens Motors are identical in their nature to those of other companies in the industry; Unlike other companies in the industry, Rubens Motors capitalizes interest on the capital employed in its long-term projects; Finally, Rubens Motors uses percentage of completion method for revenue recognition, whereas most companies in the industry employ completed contract method. Marc does not make any adjustments to Rubens financial statements, calculates the intrinsic value of its stock and issues a Strong Buy recommendation. Critique the accuracy of Marc's analysis. Solution

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Study Session 10 Asset Valuation: Basic Valuation Concepts Marc should have noticed that the quality of financial statements of Rubens Motors is definitely below the industry average. The company employs a more aggressive revenue recognition method (percentage of completion) than the rest of the industry does. It capitalizes more expenses (note capitalization of interest expense) and makes use of aggressive estimates of depreciable lives. All these accounting practices boost the company's earnings and potentially distort Marc's estimate of its intrinsic value.

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Study Session 10 Asset Valuation: Basic Valuation Concepts c. The interpretation of footnotes to accounting statements and other disclosures. Footnotes to the financial statements are their integral part, and contain valuable information about the company. Reading through the footnotes allows analysts to interpret the data provided in the accounting statements and other disclosures. Analysts may use the following information normally provided in the footnotes to improve the accuracy of valuation (this list is not exhaustive): Information on off-balance sheet activities, such as operation leases and special purpose entities; Discussion of risks pertaining to the company's business; Accounting estimates and methods, allowing to determine the quality of financial statements; Information about the company's contingent liabilities; Facts about the auditor, including any litigation with or change of the auditor.

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Study Session 10 Asset Valuation: Basic Valuation Concepts d. Alpha. When an investor identifies mispricing of an asset, he can expect to earn abnormal returns upon the convergence of the asset's price to its intrinsic value. Abnormal return, or alpha, is the difference of expected return on asset and the required rate of return, justified by the risk of such investment. Managers can use alpha for both investment decisions and evaluation of past performance. These two applications are reflected in the two alternative approaches to calculation of alpha: Ex Ante Alpha = Expected return - required return, where required return is related to the potential expected opportunities with similar risk elsewhere in the market; Ex Post Alpha = Actual return - contemporaneous required return where contemporaneous required return reflects the yield that investors could have earned elsewhere assuming similar risk during the same holding period. Example Harry Lohman is considering the inclusion of Jandex in his portfolio of small-cap tech stocks. Jandex is a web portal company, currently trading at $12 a share. A year ago Jandex traded at $20 a share, but Nasdaq Internet Index fell 60% during the last 12 months, dragging Jandex's price down as well. If Nasdaq Internet Index is used as a benchmark, Jandex's beta is 1. During the same holding period, investments in 10-year Treasury Notes yielded 8%. After the close evaluation of Jandex's customer base, its products, current competitive landscape and expected future industry trends, Harry concludes that the company's intrinsic value is at around $16 a share and expects this value to persist for a few years in the future. Even so, Harry expects that the high level risk aversion of investors after the tech crash, will lead to only 50% convergence of Jandex's stock price to its underlying value during the next year. Additionally, Harry expects Jandex to start paying dividends next year with its first annual dividend expected at $2 a share. The market expects Nasdaq Internet Index to rebound from its current lows and produce 35% return during the next 12 months. On-the-run 10-year Treasuries currently yield 3% and their price is expected to move from 105 to 101 during the next 12 months. Harry needs to estimate ex ante and ex post alphas for Jandex. Solution Clearly, the closest benchmark that returns on Jandex's stock should be compared with is Nasdaq Internet Index. Therefore, the information on Treasury notes is redundant. To calculate ex-post alpha for the last 12 months we need to compare actual return on Jandex's stock with the contemporaneous return on Nasdaq Internet Index. Notice, that Jandex did not pay dividends last year. Ex post alpha = actual return on Jandex's stock - contemporaneous return on Nasdaq Internet Index = ($12-$20)/$20 - (-0.60) = -0.40 + 0.60 = 0.20, or 20%.

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Study Session 10 Asset Valuation: Basic Valuation Concepts Even though Jandex's stock fell 40% last year, its alpha is positive since investors lost more money on other investments with similar risk. Ex ante alpha is the expected excess return on Jandex's stock during the next 12 months over the return that investors can earn elsewhere in the market assuming similar risk. A part of next year's expected return is the dividend income. Also, notice that only 50% of the difference between the stock's price and its intrinsic value is expected during the next year. Since Jandex's beta equals 1, investors should require the same return on its stock as on the Nasdaq Internet Index. Ex ante alpha = expected return on Jandex's stock - required rate of return = (($16 $12)/2 + $2)/$12 - 0.35 = 0.33 - 0.35 = -0.02, or -2%. We see that even earning 33% return is not enough for ex ante alpha to be positive in case of Jandex, since investors can earn more elsewhere without assuming more risk.

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Study Session 10 Asset Valuation: Basic Valuation Concepts e. The going-concern and non-going-concern assumptions in valuation. As we will discuss in further study sessions, most models employ forecasts of a company's fundamentals as inputs that allow analysts to estimate the stock's intrinsic value. If the company does not have a future, these forecasts are misleading and the intrinsic value should be estimated without the going-concern assumption. In that case, the value of the company should be determined by the expected proceeds of its liquidation, or the company's liquidation value. Not necessarily, a company's liquidation value should be lower than its going concern value. If the company is expected to constantly decrease shareholders' capital by engaging in projects with negative NPV, it is better to dissolve the company, since more value will be derived for shareholders form the sale of the company's assets. Such ineffective companies are usually prime targets for acquisitions. Assuming that such opportunities are quickly identified in the effective market, a company's fair value is the higher of going concern value or liquidation value.

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Study Session 10 Asset Valuation: Basic Valuation Concepts f. Absolute and relative valuation models. We have already listed some valuation models in the previous section of this study session. They can be categorized into two groups: absolute and relative valuation models. Absolute valuation models, such as Dividend Discount Model, Free Cash Flow models, and residual income model, discount some future indicators related to the company's value to estimate its absolute intrinsic value. An analyst can make investment decisions by comparing this value to the current market price. Relative valuation models do not indicate any absolute value of the company. They can only signal, whether an asset is under- or over-valued relatively to some benchmark. An important feature of relative valuation models is that their results are based on comparison between several assets. Even if some asset is considered to be relatively undervalued comparing to the benchmark, it may be overvalued in the absolute terms, if the benchmark itself is significantly overvalued and its market value is going to decline. Example Josh Lasbader is writing an industry research report on optical storage companies. He compares the companies within the industry using the P/E, EV/EBITDA and P/B ratios. Based on this analysis, he assigns one of the three ratings to each of the companies in the industry: "industry outperform", "industry average", or "industry under-perform". Nick Gruber, a private investor, reads Josh's research report and invests in all companies rated "industry outperform". He then sees his total investments dropping in value by 25% during the next 6 months. Nick calls Josh and asks for explanation behind the losses. Josh replies that he is very satisfied with his earlier research report and confirms all ratings assigned earlier. Explain why Nick and Josh differ in opinions about the effectiveness of the research report. Solution Josh employed relative valuation analysis in his research. In his report he expressed the opinion, that certain stocks will achieve higher returns than the industry as a whole. Apparently, his favorite stocks indeed outperformed the industry average. Nick is mostly interested in absolute value of his investments. Even though his investments outperformed the industry, the market dynamics for all companies in the industry was negative, which resulted in loss in absolute terms.

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Study Session 10 Asset Valuation: Basic Valuation Concepts g. The role of ownership perspective in valuation An analyst may use DDM or FCFF model to estimate the company's intrinsic value. But what if investor decides to acquire a controlling stake in the company? Should he pay more than the intrinsic value that does not take the ownership perspective into account? The answer is yes, since acquisition of control over the company allows the investor to appoint his directors to the board and make sure that company's strategy follows his decisions. For that reason, investors have to pay a control premium above the stock's intrinsic value to acquire control over the company.

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Study Session 10 Asset Valuation: Basic Valuation Concepts

Section E. Valuation Outside of the United States

a. Accounting differences. Here are major accounting differences between the US and other developed countries: Provisions

Additions to provisions are non-cash expenses that reflect future costs or expected losses. Companies make provisions by reducing income and setting up a corresponding reserve on the liability side of the balance sheet (or deducting the amount from the relevant assets). The rules for setting up provisions vary by country. o Some countries only allow provisions for specifically identifiable future costs or losses. o Some countries allow provisions for unspecified costs. In these countries companies often use provisions to manage earnings, increasing them in good years and drawing them down in bad years. o Some countries allow provisions to be tax-deductible. Provisions often are the single largest difference between US GAAP and the local accounting statements. Pensions

Pension systems differ greatly by country. o Companies in the UK and Netherlands are required to have pension plans independently managed by pension fund managers or insurance companies. o In Germany, pensions obligations are simply recorded as liabilities on the financial statements to be eventually paid out of the operating cash of the company. Countries approaches to funding pension plans also vary. In most countries, companies are required to disclose under-funding in the main body of the financial statement or in the notes. Goodwill

In some countries goodwill can be written off directly against equity at the time of the acquisition. In other countries it is capitalized and amortized. IAS GAAP: Amortize over a period not to exceed 20 years unless a longer period can be justified. Research costs should be expensed as incurred.

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Study Session 10 Asset Valuation: Basic Valuation Concepts U.S. GAAP: Intangible assets (other than goodwill) should be amortized over their useful lives. If the useful life is indefinite (goodwill), the intangible asset should not be amortized, but subjected to an annual test for impairment. Research costs should be expensed as incurred. In most cases, ROIC should be calculated both with and without goodwill. o ROIC excluding goodwill measures the operating performance of the company and is useful for comparing operating performance across companies and analyzing trends. o ROIC including goodwill measures how well the company has used its investors funds. That is, considering the premiums it paid for acquisitions, has the company earned its cost of equity? The proper way to include goodwill in the ROIC calculation is to add to invested capital the total amount of goodwill before cumulative amortization and not to deduct from NOPLAT any goodwill amortization. In effect, this reverses the amortization of goodwill. Fixed-Asset Revaluation

IAS GAAP: Can use either historical cost or a revalued amount. o Revaluation gains are credited to owner's equity. o Revaluation losses that offset previous revaluation gains are charged to owner's equity until gains are eliminated, and then charged to income. In practice, however, upward revaluation is most likely to be limited to tangible assets, since upward revaluation of intangible assets can only occur if the intangible assets value can be determined by reference to an active market for the intangible asset. Revaluation of the entire class of assets is required when an asset is revalued. Upward revaluation should not pose a problem for investors: o When a company revalues its assets upwards, its notes will disclose the historical cost based information. o Revaluation gains above an assets historical cost go straight to equity and not income. U.S. GAAP: Historical costing only. As in the case of goodwill, ROIC should be calculated both with and without revaluation. o Revaluation including revaluation measures the operating performance of the company irrespective of when the assets have been bought and is useful for comparing operating performance across companies. o ROIC excluding revaluation measures how well the company has employed its investors funds. That is, considering the actual cost paid for fixed assets, has the company earned its cost of capital?

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Study Session 10 Asset Valuation: Basic Valuation Concepts The most appropriate way to take revaluation into account is to annually adjust NOPLAT (net operating profits less adjusted taxes) and invested capital to reflect the annual increase of market values. Deferred Taxation

Deferred taxes arise from differences between a companys published financial statements and its tax accounts. In some countries such as Germany, Switzerland and Italy, deferred taxes normally dont arise in the accounts of individual companies because financial statements are the same as tax accounts. However, deferred taxes may arise in consolidated accounts. In other countries deferred taxes could be substantial because of items such as asset revaluation and accelerated depreciation. Income taxes should be stated on a cash basis to calculate NPPLAT, invested capital and ROIC. The increase in deferred taxes (a liability) should be subtracted from the amount of taxes on the income statement to calculate EBIT. Consolidation

Most countries require consolidation of accounts when a subsidiary is more than 50% owned, or when there is a controlling interest. See study session 5, section H (Analysis of Business Combinations) for details. Foreign Currency Translation

See study session 6, section A (Analysis of Multinational Operations) for details. Non-operating Assets

In some countries, non-operating assets can be significant. For example, many Japanese companies own minority interests in the common stock of their business partners (customers and suppliers). These assets remain on the books at their historical cost but should be converted to their current market value in your valuation.

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Study Session 10 Asset Valuation: Basic Valuation Concepts b. Taxation. Tax rules vary across countries. We will highlight one important issue: how to deal with corporate and personal tax integration? To be completed.

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