Chapter 11 Questions
• How do we apply the DDM to the valuation of a firm that is expected to experience temporary supernormal growth? • How do we apply the present value of operating cash flow technique? • How do we apply the present value of free cash flow to equity technique? • How do we apply the relative valuation approach? • What are the major relative valuation ratios?
A Three-Step Process
• There is academic support for this top-down approach
– Most changes in individual earnings related to changes in aggregate earnings and changes in a firm’s industry – There is a relationship between stock and bond prices and macroeconomic variables – Rates of return for individual stocks can be explained by the aggregate stock market and the firm’s industry
What determines the value of an asset?
• The value of a financial asset is the present value of expected future cash flows received from the asset • Required inputs:
A Three-Step Process
Bottoms up to the top down approach! It works!
Review of Valuation Components
• The value of a financial asset is the present value of its expected future cash flows • Two components:
Chapter 11 Questions
• What conditions make it appropriate to use the relative valuation techniques for valuing a company’s equity? • What are the major discounted cash flow valuation techniques? • What is the dividend discount model (DDM), and what is its logic? • What is the effect of the assumptions of the DDM when valuing a growth company?
• The particulars of the valuation process vary by type of investment
The Valuation Process
• Two basic approaches:
– Top-down, three-step approach – Bottom-up, stock-picking approach
Investment Decision Process
• Once expected (intrinsic) value is calculated, the investment decision is rather straightforward and intuitive:
– If Estimated Value > Market Price, buy – If Estimated Value < Market Price, do not buy
A Three-Step Process
• Within the three-step process of the top-down approach, all steps are crucial • General economic influences
– Government policies strongly influence the economic environment, leading to profound effects on industries – We can see the influence of changes in the overall economy on various classes of investments
1. The real risk-free rate of return, plus 2. The expected rate of inflation, plus 3. A risk premium to compensate for the uncertainty of returns
• Company Analysis
– Individual investments will either make or break portfolio performance – Once well-positioned industries are determined, find well-positioned firms within those industries
– Dividends – Interest payments – Capital gains
• Cash flows are sometimes easy to estimate (E.g. Government bonds) but can also be very difficult to estimate (E.g. Growth stocks)
Chapter 11 Questions
• How do we determine the value of bonds? • What causes a change in the value of a bond? • How do we determine the value of preferred stock? • What are the two primary approaches to the valuation of common stock? • Under what conditions is it best to use the present value of cash flow approach for valuing a company’s equity?
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General Approaches to Security Analysis
• Top-Down Approach (Our focus)
1. Review the macro-economy 2. Analyze different industries and sectors 3. Determine buy/sell candidates
•
Bottom-up Approach
– Focus primarily on the firm-specific factors that will lead to finding undervalued companies, regardless of industry or macroeconomic factors
Chapter 11
AN INTRODUCTION TO VALUATION
Chapter 11 Questions
• When valuing an asset, what are the required inputs? • After we have valued an asset, what is the investment decision process? • What are the tow major approaches to the investment decision process? • What are the specifics and logic of the top-down, three-step approach?
– A discount rate used to calculate the present value of the cash flows – The stream of expected future cash flows
Discount Rate
Determined by:
1. The real risk-free rate of return (to compensate for the time for which funds are invested), plus 2. The expected rate of inflation, plus 3. A risk premium to compensate for the uncertainty of returns
– The required rate of return on the investment – The stream of expected future returns, or cash flows