FNE Security Analysis PRELIM

Investment environment

In our lifetime, we earn and spend money, however it is not unusual that our current money income
balanced exactly with our consumption desires. The imbalances lead either to save or to borrow to get the most
benefits from our income. When there is an excess, we tend to save, we do that by simply keeping it in our
possessions for some future needs which means we forgo present consumption for future consumptions which is
really the primary intention when we save.
When we gave up possessions of our savings for some other ways or reason like putting it in investment
or business activities, we expect to get future gains, conversely if we do not have savings or we spend more than
what we earned we tend to borrow and also expect or experience paying in the future the amount more than we
borrowed.
The rate of exchange between current and future consumption is referred as pure rate of interest or we
may also call it as a pure time value of money. This interest rate is established by the interaction of the supply
of available excess income and demand for excess consumption. ex. If you have 100 pesos and exchange it for
105 pesos a year from now, the pure rate of exchange in a free risk investment is 5 percent as such you gain,
assuming the price level remain the same. However, if there is an expectation of increase in price level or
uncertainty of gains the demand for higher nominal risk-free interest rate is desirable. That means people
invest their savings to earn and expect real value returns from their deferred consumption.
Investment then is the current commitment of money amount for certain period of time to derive future
payments that will compensate them for the time the money is held in investment, expectation of changes in the
inflation rate or changes in general price level, and uncertainty (risk) of future payments. Such rate of
compensation or returns in investing is known as investor’s required rate of return.
In investing in financial assets such as equity assets like common or preferred stocks, the value of a
particular asset is crucial in determining the success and failure of the investment goals specifically such value
is an ownership stake. In determining the value of asset received for equivalent money paid and the differences
in risk adjusted return of a financial asset (ex. Stocks at current prices), valuation is necessary. VALUATION is
an estimate of an asset’s value based either on variables perceived to be related to future investment gains or
returns or on comparisons with similar assets.

Scope of equity valuation

1. Selecting stock. an attempt to identify securities as fairly valued, overvalued, or undervalued, relative to
either their own market price or prices of comparable securities.

2. Inferring (extracting) market expectations . Market prices reflect the expectations of investors about
future prospects of companies. It includes historical and economic reasons that certain values for
earning growth rates and other company fundamentals (characteristics of a company related to
profitability, financial strength, risk) may or may not be reasonable. The extracted expectation for a
fundamental characteristic may be useful as benchmark or comparison value of the same characteristics
for another company.

3. Evaluating corporate events. Valuation tools are used to assess the impact of corporate events such as
mergers (combination of two corporations), acquisitions (combination of two corporations however it
connotes that the combination is not one of equals), divestiture (a corporation sells some major
components of its business), spin-off ( corporation separates off and separately capitalizes component
business, which is then transferred to the corporation’s common stockholders), management buyouts
(MBO’s) (management repurchases all outstanding stocks, usually using the proceeds of debt issuance),
and leveraged capitalization (some stock remains in the hands of the public. Each of these events may
affect a company’s future cash flows and in turn the value of equity. Another thing, in mergers and
 acquisitions, the company’s own common stock is often used as a currency for the purchase that makes
investors wanting to know whether the stock is fairly valued.

4. Rendering fairness of opinions. The parties in merging transactions may be required to seek a fairness
opinion on the terms of the merger from a third party like investment bank and the core of such opinions
is valuation.

5. Evaluating business strategies and models. Companies which are concerned in the maximization of
shareholder value must evaluate the impact of alternative strategies on share value.

6. Communicating with analysts and shareholders. Valuation concepts facilitate communication and
discussion among company management, shareholders and analysts on a range of corporate issues
affecting the company value.

7. Appraising private businesses. To determine the value of common stock of private company since those
stocks of private company are not traded publicly, as such comparison of the estimate of the stock’s
value with a market price is difficult if not attainable. Valuation of private companies has special
characteristics. The challenges in valuation appear in evaluating initial public offerings (IPO’s) (initial
issuance of common stock registered for public trading by a formerly private corporation).

Valuation and portfolio management

The analysis of equity investments is done within the context of managing a portfolio. An investor’s
most basic concern is generally not the characteristics of a single security but the risk and return prospects of
his/her total investment position.
In a portfolio perspective, investment process steps are planning, execution, and feedback that includes
evaluating whether objectives have been achieved, and monitoring and rebalancing of positions. Valuation is
closely associated with the planning and execution steps.

Planning - Investors identifies and specifies investment objectives which are the desired outcomes in
relation to risks and returns, and constraints (internal and external limitations on investment actions). An
important component of planning is the concrete elaboration of an investment strategies, or approach to
investment analysis and security selection with the goal of organizing and clarifying investment decisions.

Valuation is relevant and critical to active investment strategies. In active management, the concept of
benchmark (the comparison portfolio used to evaluate performance which for index manager is the index
itself) is useful. Active managers hold portfolios that differ from the benchmark so as to produce superior risk-
adjusted returns. Securities held in different-from-benchmark weights reflect expectations that differ from
consensus expectations (differential expectations). The active managers must translate expectations into value
estimates, so as to ranked securities from relatively most attractive to relatively least attractive which then
requires valuation models. In planning stage, the active investor may specify narrowly the kinds of active
strategies to be used and also specify in detail valuation models and/or criteria.

Execution - The manager integrates investment strategies with expectations to select a portfolio (portfolio
selection/composition problem) and portfolio decisions are implemented by trading desks (portfolio
implementation problem).

Valuation Concepts and Models

Each of a single valuation is a process with the following steps:

1. Understanding the business. It involves industry prospects evaluation, competitive position, and corporate
strategies, and financial statement to forecast performance.

2. Forecasting company performance. It includes forecasts of sales, earnings, and financial position (pro-forma
analysis) are the immediate inputs to estimate value.

3. Selecting the appropriate valuation model

4. Converting forecasts to a valuation

5. Making the investment decision (recommendation).

Valuation Concepts and Models

Each of a single valuation is a process with the following steps:

1. Understanding the business. It involves industry prospects evaluation, competitive position, and
corporate strategies, and financial statement to forecast performance.

The first task in understanding a company is to understand the firm’s economic and industry context and
management’s strategic responses since economic and technological factors affect all companies in an
industry and industry knowledge leads the analyst understand the basic characteristics of the markets served
by a company and the economics of the company. With such information, the analyst is in a position to
evaluate risk and forecast future cash flows.

Porter suggests focusing on the following questions;

A.) How attractive are the industries in which the company operates, in terms of offering prospects for
sustained profitability. Inherent industry profitability is one important factor in considering company’s
profitability as well as industry structure which is about the industry’s underlying economic and technical
characteristics and trends affecting the structure. Current facts and news concerning all industries in which
company operates should be considered such as:

1. Industry size and growth overtime

2. recent developments (management, technology, finance)
3. overall supply and demand balance
4. subsector strength/softness in the demand-supply balance
5. qualitative factors such legal and regulatory environment.

B.) What is the company’s relative competitive position within the industry – level and trend of the company’s
market share

C.) What is the company’s competitive strategy?

1. Cost leadership – lowest cost producer, low prices or near the industry level
2. differentiation – offers unique products or services valued by most customers
3. Focus – seeking competitive advantage within a target segment/s.
D.) How well is the company executing its strategy – competent execution

2. Forecasting company performance. It includes forecasts of sales, earnings, and financial position (pro-
forma analysis) are the immediate inputs to estimate value.

A. Economic forecasting – Industry and competitive analysis take place within the larger context of
macroeconomic analysis.

1. Top-down Forecasting Approach -from international and national forecasts to industry forecast then
to individual company and assets forecasts. Exhibits similar assumptions.

2. Bottom-up Forecasting Approach – from aggregate individual company forecasts into industry
forecasts, and then macroeconomic forecasts. This approach encounters problem of inconsistent
assumptions.

B. Financial Forecasting – Integration of the analysis of industry prospects and competitive and corporate
strategy with financial analysis to formulate specific numerical forecasts of items such as sales and earnings.

1. Use of accounting information and financial disclosure to determine accuracy of the quality of
earnings analysis.

3. Selecting the appropriate Valuation Model.

1. Absolute Valuation Model – specifies an asset’s intrinsic value. It can supply a point estimate of value than
can be compared with assets market prices.

1. Present value model or discounted cash flow model of equity valuation considers the value of
common stock as being the present or discounted value of its expected future cash flows.

1. Dividend cash flow models – present value models based on dividends. Dividends represent
cash flows at the share-holder level. At company’s level-level definitions of cash flow are

1. Free cash flow – based on cash flow from operation but takes into account the
reinvestment in fixed assets and working capital for on-going concern. Present value
models based on a free cash flow concept include free cash flow to equity model and
the free cash flow to the firm.

2. Residual income models- present value models of equity valuation based on accrual
accounting earnings in excess of the opportunity cost generating those earnings.

2. Relative Valuation Models – specify an assets value relative to that of another asset. The idea underlying
relative valuation is that similar assets should sell at similar prices, and relative valuation is typically
implemented using price multiples such as price-earnings multiple (P/E). Relative valuation involves group of
comparison asset, such as industry group, rather than single comparison asset, and the comparison value of
P/E might ne the mean or median of the P/E for the group assets. The approach of relative valuation as
applied to equity valuation is often called the method of comparable.
The broad criteria for model selection are valuation models should be

1. Consistent with the characteristics of the company being valued.

2. Appropriate given the availability and quality of data.
3. Consistent with the purpose of valuation, including the analyst’s ownership perspective.

Value Perspectives

Value perspectives serve as the foundation for the variety of valuation models. The quality of the
analyst’s forecasts in particular the expectational inputs used in valuation models is a key in determining
investment success. To be consistently successful, the manager’s expectations must differ from consensus
expectations and be, on average correct as well. When accurate forecasts are combined with appropriate
valuation model a useful estimate of intrinsic value is obtained. Intrinsic value of an asset is the value pf the
asset given a hypothetically complete understanding of the asset’s investment characteristics.

Valuation is an inherent part of the active manager’s attempt to produce positive excess risk-adjusted
return also called abnormal return or alpha. The manager hopes to capture a positive alpha as a result of his
efforts to estimate intrinsic value, as such any difference of market price from manager’s estimate of intrinsic
value is considered or perceived as mispricing (difference between estimated intrinsic value and market price
of assets. Any mispricing becomes part of manager’s expected holding period return estimate, which is the
manager’s forecast of the total return on the asset for some holding period. An expected holding period
return is the sum of expected capital appreciation and investment income, both stated as a proportion of
purchase price. Expected capital appreciation incorporates the investor’s perspective on the convergence of
market price to intrinsic value. In ex ante alpha (in forward-looking senses), an asset’s alpha is the manger’s
expected holding period minus the fair return also called required rate of return.

Ex ante alpha = expected holding period return minus required rate of return

Example: Assume that an investor’s expected holding period return for a stock for the next 12 months is 12
percent, the stock required rate of return is 10 percent, then ex ante alpha will be 12 – 10 + 2 percent.

In ex post alpha (in backward-looking sense, alpha is actual return minus contemporaneous required return
(the investments of similar risk actually earned during the same period.

Ex post alpha = actual holding-period return minus contemporaneous required return

Example: Assume that a stock has a return of -5 percent after several years and the contemporaneous
required return was -8 percent, then ex post alpha will be -5 – (-8) = 3 percent.

No matter how equity analyst works to identify mispriced securities, uncertainty is associated with
realizing a positive alpha. Even the analyst is confident about the accuracy of forecasts and risk adjustment,
there is no way of ensuring the ability to capture the benefits of any perceived mispricing without risk.
Convergence of the market price to perceived intrinsic value may or may not happen within the investment
horizon. One uncertainty in applying any valuation methodology concerns whether the analysts has accounted
for all sources of risk reflected in an asset’s price since there is always competing equity risk models.
Required rate of return is the interest rate used to find the fair present value of a financial security. It is a
function of the various risk associated with a security as such the interest rate investors should receive on the
security given its risk. It is also an ex ante(before the fact) measure of interest rate on a security.

Holding period is the period during which you own an investment and the return is called holding-period
return

HPR= ending value of investment / beginning value of investment ex. 220/200 = 1.10, the value will always be
zero or greater and never be a negative value.
Converting HPR to an annual percentage rate is to derive a percentage return which is the holding period yield
(HPY). HPY = HPR – 1.

1/n
Annual HPR = HPR (n is the number of years the investment is held)

Other Value measures

A company generally has one value if it is immediately dissolved, and another value if it continues in
operation.

a. Going-concern assumption is the assumption that the company will maintain its business activities into
the foreseeable future.
b. Going-concern value is the company’s value under a going-concern assumption.
c. Liquidation value is the company’s value if it were dissolved and its assets sold individually. The value
added by assets working together and by human capital used to manage those assets makes estimated
going-concern value greater than liquidation value. The higher the going-concern value or liquidation
value is the company’s fair value which is the price at which an asset (or liability) would change hands
between a willing buyer and a willing seller when the former is not under any compulsion to buy and
the latter is not under any compulsion to sell.