Impact of Discounted Cash Flow Method and Price-Earnings Model on Investor

Decision Making- Using Apple Inc Financial data from 2011 to 2020
Introduction:
The investor has a keen interest in the value of the company in the market for investment
purposes, either its large-cap company or a small-cap company. The investor uses different
valuation models for valuation, and these valuation models are based on different variables
and some specific assumptions. This research tries to identify the impact of absolute and
relative valuation models on investor investment decisions. The research by Kaplan and
Ruback (1995) and Olsson and Oswald (2000) in this field focuses on identifying which
valuation model is better but does not focus on how these models impact the investors'
decisions. This research helps ascertain the factors that change the value of stock price under
different valuation models and their impact on investor decisions. Here to carry out this
research, questions were answered like is stock underpriced or overpriced as per both
valuation models, what are the reasons for the difference between the market price and
intrinsic value and what are impacts on investor decisions. Quantitative methods are applied
to the financial statements of Apple inc from the Year 2011 to 2020 to answer research
questions. Apple Inc Company is selected as a case study as it is one of the large-cap tech
companies in the New York Stock Market, with $2,346.60 billion (Nasdaq). Its main
operation is to design and manufacture mobile and other portable mobile devices like laptops
and digital music devices with different and unique features and quality(Annual report 2021).
This company is selected for analysis because it is one of the largest tech companies, and the
future of the world lies in living with technology.

Research and Aim:

This research aims to analyze the impact of the discounted cash flow method or dividend
discount model on the investor's future decision-making using a quantitative analysis
strategy. This study tries to identify whether investor decisions remain the same or change
with a change in the method of business valuation model of the company. The following
questions are addressed in this study to analyze this impact:

1. Is stock underpriced or overpriced as per both valuation models?

2. What are the possible reasons for the difference between market value and intrinsic
value under discounted cash flow method and Price-earnings model?
3. What is the impact of these two different valuation models on investment decisions?

Literature review:

Financial analysts, investors, practitioners, and other market practitioners use the common
stock valuation model to ascertain the value of the common stock to discover mispricing
between intrinsic Value and market price, providing investors with buy-sell
recommendations. Business valuation is an integrated theory (2008); Absolute and relative
valuation models are used to determine the intrinsic value of the common stock. The most
common absolute valuation model is the dividend discount model, discounted cash flow
method, and residual income model. In contrast, the relative valuation model is based on the
price multiples such as Price-earnings, Price book value, Price cash flow, Price-earnings to
growth, and enterprise value to earnings before interest taxes, depreciation, and amortization.
In this research impact of absolute valuation model discounted cash flow and relative
valuation model price earnings ratio on investor decision are analyzed. These two methods
are selected here because absolute valuation model discounted cash flow entirely based solely
on the company data and expected movement while relative valuation model price earnings
ratio derive the value from the market information of the firm and industry directly,
incorporating market trends and conditions. Study of these two models on the financial data
of Apple Inc from 2011 to 2020 help in understanding the deviation in investor decision if
different valuation model is used and which model provide more accurate results. Spemann
and Schreiner (2007) state that the relative valuation model can be presented more quickly
than the absolute model and is mostly preferred by the analyst.

Valuation model and its impact on stock intrinsic price:

Kaplan and Ruback (1995) study the deviation in the intrinsic value as per absolute valuation
model and relative valuation model, and they find a significant difference between the
intrinsic values as per absolute and relative valuation model. Francis, Olsson, and Oswald
(2000) also compared the valuation as per absolute and relative valuation models to ascertain
which method provides results closer to market value and found that residual income
valuation (one of the relative valuation models provides results much closer to market price.
These two studies are reviewed here because both studies were carried out to ascertain the
relationship between the absolute and relative valuation model.

The possible reason for the difference between intrinsic values and market value:

Ardy Indra (2019) study the difference in intrinsic value with stock market price using the
price-earnings ratio approach as an investment decision-making indicator. In this research,
the author has used the surveyed method with descriptive research in which data is collected
from a sample that represents the whole population. The findings of this report show that
investors who aim to earn dividends hold the shares when stocks are overvalued, while the
investors who want to earn capital gain sell the shares. While in the case of undervalued
shares, investors were not interested in buying because the development of the company's
fundamental variables decreased. This study is important because it studies investor
behaviour in relation to market value and intrinsic value.

Impact of these differences on investment decisions of investors:

Investor sentiment's effects on share price deviation from their intrinsic value based on a
fundamental accounting study by (Yiannis, Stella, and Elias, 2020) study the effects of
investor sentiments on the market price of stocks using the residual income valuation model
to calculate the intrinsic value of the common stock. This study shows the generic effect of
investor sentiments on the stock price. The investor sentiment effect is positive in the low-to-
normal sentiment regime. In contrast, the effects are negative in the excess-sentiment regime
due to abrupt changes in the fundamental values of the company. This study is considered
here because it addresses one of the major issues of difference in the market price and
intrinsic value of the stock, which is important to understand before analyzing the impact of
same on investors' decisions.

Research gap:

This study is different from the study conducted by Kaplan and Ruback (1995), Olsson, and
Oswald (2000), because this study tries to find out which valuation model is superior or
provide result nearest to market value but not focus on its impact on the investor decision.
While Ardy Indra (2019) only focuses on investor behaviour relative to market conditions
and (Yiannis, Stella, and Elias, 2020) study the effects of investors sentiments on market
price using the residual valuation, this research aims to identify the impact of absolute
(Discounted cash flow method) and relative valuation model (Price earnings model) on
investor decision as well as other reasons of differences in market price and intrinsic value.
Methodology:

Objective 1: Is to identify whether the stock is under-priced or overpriced:

There are various absolute and relative valuation models. The dividend discount model
discounted cash flow method; residual income valuation model is some of the examples of
absolute valuation models, while Price-earnings ratio(P/E), Price to book value ratio (P/BV),
Price to cash flow ratio(P/CF), Price to sales ratio(P/S), etc. are an example of relative
valuation model. Here discounted cash flow method from the absolute valuation model and
the price-earnings valuation model from relative valuation models are used here to ascertain
whether the stock is underpriced or overpriced.

Brigham & Gapenski (1997) states that discounted cash flow methods are used here because
it determines the company's value using the concept of the time value of money, making it
more suitable for valuation as it considers the loss in the value of money with time. The study
by Brealey, Myers, & Allen (2006) states that the DCF valuation model valued the company
using the concept of the value additive. Means this method used free cash flow for valuation
and tax shield. This is one of the best valuation methods because it considers free cash flow,
which indicates pure equity financing, which helps derive the company's true value.

Discounted Cash flow Method =[ FCF(1+g)]/(1+r)^n

Here: FCF is free cash flow

g is growth rate
r is discount rate
n is number of years

The price-earnings ratio is selected because investors are generally interested in the earnings
capacity per share. After all, Price and dividend depend on the EPS. It indicated what
investors are willing to pay to earn earnings per share. The study of Heins and Allison (1966)
states that stock returns are closely related to stock prices. The study of Pinches and Simon
(1972) found that both the annual and holding period returns were higher for the low-price
stocks than for the higher price ones.

Price Earnings Ratio = Stock Price in Market / Earnings Per Share

Objective 2: Identify what are the reasons for differences between stock market price
and intrinsic Value:

Quantifiable study of the reason differences between stock market price and intrinsic value of
the stock is not possible because the stock price is affected by the qualitative characteristics
of market condition and the internal strength of the company to overcome the market threat
and grasp the market opportunity. Therefore the reason for the difference between stock
market price and intrinsic value is identified by studying the impact of the different market
conditions on the stock price. These market conditions have both positive and negative
impacts on the movement of the share price. These objectives are solved by quantitative
study of the movement in the stock price before and after the news release, announcements of
dividends, the introduction of new products in the market.

Objective 3: Is to identify the impact of different valuation models on investment

decisions:

Differences in market price and intrinsic Price of a share play a vital role in the investment
decision of the investors. In this, whether the discounted cash flow absolute method and price
earnings ratio relative method provide the same investment decision or investment decision
changes with change in the valuation model is identified. To identify this, the Value of stocks
of Apple Ins is identified for period from year 2011 to Year 2020 using the discounted cash
flow absolute relative valuation model and price earnings ratio relative valuation model. Then
compared the same with the prevailing market price of the stock and identify the investment
decision (based on given below table). And after that, investment decisions under each
valuation model are compared with each other to extract whether investment decisions are the
same or different under different valuation models.

Comparison table:

Condition Decision
Intrinsic Value > Market Price Buy
Intrinsic Value < Market Price Sell
Intrinsic Value = Market Price Indifferent
Reference:

AAPL 2022, Annual Report 2021, AAPL, viewed 13rd June 2022,
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Brealey, R. A., Myers, S. C., & Allen, F. (2006). Principles of Corporate Finance (8th Edition ed.).
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Brigham, E. F., & Gapenski, L. C. (1997). Financial Management - Theory and Practice (8th Edition
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Fisher, Kenneth L. 1984. Super Stocks. Homewood, Illinois: Dow Jones-Irwin.

Francis, Jennifer, Per Olsson, and Dennis R. Oswald (2000), “Comparing the Accuracy and
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Karaviasa, Y., Spiliotib, S., &Tzavalisb;, E. (2020). Investor Sentiment Effects on Share
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