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Investment Analysis
Lecture 5
The Valuation Process
Nadir Khan Mengal
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Investment Analysis
The top-down 3 step approach
ECONOMIC
ANALYSIS
INDUSTRY
ANALYSIS
Nadir Khan Mengal
FIRM/STOCK
ANALYSIS
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Investment Analysis
The top-down 3 step approach (cont’d …)
Step 1: Forecast macroeconomic influences
•
Fiscal Policy is a direct approach aimed at overall consumer demand in an attempt to manage the rate of
economic growth. Tax cuts encourage spending (demand) and speed up the economy, tax increases discourage
spending and slow down the economy. Government spending creates jobs, thus increasing overall demand.
•
Monetary Policy is an indirect method used by the government to manage economic growth. Decreasing the
money supply causes interest rates to rise, putting upward pressure on costs and downward pressure on demand.
Increasing the money supply reduces the cost of money and increases demand. Inflation can result from
increasing the money supply too fast. Rising interest rates reduce the demand for investment funds and rising
consumer prices reduce product demand.
Step 2: Determine industry effects
•
Identify industries which, given your economic forecast, should prosper or suffer. Consider how these industries
react to economic change: some industries are cyclical, some are counter-cyclical and some are noncyclical.
•
Consider global economic shifts: an industry’s prospects within the global business environment determine how
well or poorly individual firms in the industry will do. Thus, industry analysis should precede company analysis.
Step 3: Perform firm analysis
•
After performing an economic analysis, compare firms within each industry using financial ratios and cash flow
analysis. For stock purchases, identify the company with the most upside potential. For short selling, identify the
firm that should reach most negatively. This involves not only examining the firm’s past performance but also its
future prospects.
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Investment Analysis
Quantitative v/s Qualitative Variable
• An analyst will use all of the information available
about the economy, industry and firm to project
specific quantitative factors such as earnings, sales
and margins etc.
• These forecasts invariably are influenced by the
analyst’s subjective evaluation of qualitative factors,
such as the quality of the firm’s management team, the
transparency of its performance and the analyst’s
confidence in the firm’s (and industry’s) accounting
practices.
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Investment Analysis
Calculating Alpha
•
The intrinsic value of an asset is a function of its investment characteristics. For an
active manager to be successful in producing an abnormal return or alpha, the
valuation process must be successful in identifying investment opportunities that
are mispriced by the market. The amount by which an investment is mispriced
becomes a part of the total return expected by the manager over the holding
period.
Ex ante alpha = expected return – required return
•
•
The required return equals the fair return expected on like assets, given their level
of risk. (An asset pricing model like CAPM is typically used to estimate the required
return.)
On an ex post basis, alpha can be measured based on the historical return earned
on similar assets (adjusted for risk) during the period:
ex post alpha = historical holding period return – historical return on similar assets
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Investment Analysis
Calculating Alpha – Example
• The required return for holdings in the widget
industry is expected to be 10%. An analyst has
determined that the market has undervalued CCC
Widget, Inc., by $1.25 per share, resulting in a
market price of $8. she expects this mispricing to
be corrected over the next 12 months. Se also
forecasts additional price appreciation of $0.925.
Calculate the ex ante alpha of Widget, Inc.,
shares.
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Investment Analysis
Example (cont’d …)
• The ex ante alpha is equal to the expected return less the required
return. Since at a $8.00 market value, the stock is underpriced by
$1.25, the fundamental value is $9.25. in this case, the expected
return is:
($9.25 - $8.00) + $0.925
Expected Return =
=27.2%
$8.00
• The ex ante alpha = 27.2% - 10% = 17.2%
• Even if the valuations are perfectly accurate and base on accurate
expectations, there is no guarantee that the market price will
converge to the intrinsic value over the holding period and generate
the positive alpha returns.
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Investment Analysis
Going-concern & Non-going-concern assumptions in
valuation
• The concept of a firm’s value has also been approached from other
perspectives. A going-concern value is based on the assumption that the
firm continues operating and the future dividends arise from its continued
operation rather than the sale or liquidation of its assets.
• Liquidation value is based on the assumption that the firm will cease to
operate and all of its assets will be sold (i.e., the firm is a non-goingconcern).
• Another basis for determining value is the concept of fair value, which
represents the price at which a willing buyer and willing seller would
exchange the asset or liability in an arms-length transaction.
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Investment Analysis
Ownership Perspective in Valuation
•
There are three other factors that influence the determination of value and the choice of
appropriate models resulting from the perspective of who owns the shares.
1.
Premiums for control: The concept of control is based on the ability of controlling shareholders to
determine how the assets of the firm are deployed and financed by making operating and
financing decisions. This ability can b very valuable and must be included in the valuation of a
controlling position. The converse is true also – the value of minority positions will not be
valuable.
2.
Discounts for lack of marketability: The value of non-publicly-traded shares will be discounted
because they cannot be as freely traded in a timely manner. Maximizing the value of such
positions will require time and expense to locate a buyer for whom the position has the highest
value. This expense is discounted from the value of the position.
3.
Discounts for lack of liquidity: The discount for lack of liquidity is closely related to the discount
for lack of marketability. Lack of liquidity means that it may require additional time to sell the
position and the perceived cost of this delay is deducted from the value of the position. Lack of
liquidity can arise due to either the nature of the position, (e.g., non-publicly-traded shares) or
the size of the position in relation to its normal trading volume.
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Investment Analysis
Taxes & Execution Costs and International Investments
•
Taxes can be imposed by the governments of both the investor’s country and the foreign
country in which the investment is made. There are three different forms of tax:
1.
Capital gains are taxed in the country where the investor resides.
2.
Income tax creates a jurisdictional conflict between the two countries. The international
convention is to make sure the tax is paid in at least one country. This is accomplished by
the foreign country applying a withholding tax to dividends and the investor receiving the
net amount. The home country then taxes the gross amount of the dividends but gives the
investor a tax credit equal to the foreign country withholding. The result is that the investor
pays the percentage tax rate that applies in the investor’s home country.
3.
Transaction taxes are taxes imposed on trades. They have been eliminated or significantly
reduced in most countries.
All of these taxes add to the cost of international investing and ultimately reduce the total return.
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Investment Analysis
Taxes & Execution Costs – Example
• Suppose a US investor buys 100 shares of SAP systems listed in
France on CAC, quoted at €14.5 per share (including commissions)
for a total trade cost of €1.450. the current exchange rate is $0.90
per €. The US currency cost is $1,305 for the entire trade, including
commissions charged by the US broker.
Three months later, a dividend of €1 is paid for each share owned.
Dividends are subject to a 15% withholding tax in Germany and
there is a 28% tax on short-term capital gains and dividends in US.
At this point the investor decides to sell the 100 shares of SAP, now
worth €16 per share. The current exchange rate is $0.95 per €.
Calculate the impact of taxes on the total return.
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Investment Analysis
Example (cont’d …)
Capital gains
•
$ proceeds from sale (100 shares) = €16 x 100 x 0.95/€ = $1,520
•
Pre-tax capital gain = $1,520 - $1,305 = $215
•
Taxes paid to US tax authority = $215 x 0.28 = $60.20
Dividends
•
Pre-tax dividends = 100 shares x 1€/share x $0.95/€ = $95
•
Taxes paid to US tax authority = $95 x 0.28 = $26.60
•
Tax withholding to German tax authority $95 x 0.15 = $14.25
•
Tax credit received from US tax authority = $14.25
•
Note that the investor pays the US income tax rate 28%, ($26.60) on the dividend of $95. $14.25 goes to
the German tax authority and $12.35 ($26.60 - $14.25) to the US tax authority.
The impact of taxes on total return is 6.7%
•
Total pre-tax return = $310/$1,305 = 23.8%
•
Total after-tax return = $223.02/$1,305 = 17.1%
•
Impact of taxes on total return = 23.8% - 17.1% = 6.7%
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Investment Analysis
Components of Execution Cost
Execution costs include both tangible and intangible trading costs. The three
primary execution costs are as follows:
1.
2.
3.
Commissions, fees and taxes are tangible execution costs, such as negotiated
broker fees to handle and clear a trade, taxes imposed by various governments,
fees for post-trade settlement etc.
Market impact is an intangible cost equal to the price adjustment needed to
purchase liquidity. The size of the impact depends on the order size, market
liquidity and the desired execution speed. This price adjustment is defined as the
price difference between the time the order is submitted and when the actual
trade occurs.
Opportunity cost is an intangible cost associated with the delay in or failure to
complete an individual trade. Opportunity costs are significant for investors in
market where adverse price movements and information leakage are common.
Non-execution may result in high costs.
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Investment Analysis
Components of Execution Cost (cont’d …)
Cost
Definition
Influencing Factors
Commissions
Explicit fee charged by
broker for services
Liquidity, stock and order
size
Market Impact
Cost of immediate
execution or cost of
buying liquidity
Large orders, market
liquidity, quicker
executions incur higher
costs
Opportunity
Cost of failing to find
liquidity or failure to
execute trade
Slower order executions
incur higher costs
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