Tu Lect1 Intro New

ANALYSIS OF
EQUITY
SECURITIES
Define Valuation and

Intrinsic Value
CLASS 1
1
SMU Classification: Restricted
Why we analyze Equity Securities? --

Get rich and stay rich!
“Only 3 ways to get rich” – Fred Young
Inherit it
This course won’t

help you much,
sorry…
Build wealth over
Marry it
time
“3 ways to get rich”
Invest in
something of value
This course can
help …
Preserve wealth
“Staying rich”
| 2
… investing always requires…
▪ Estimating intrinsic value independently of market price

- market price can deviate from intrinsic value due to
1) sentiment
2) market frication (e.g., limited investors’ attention)
• Undervalued stocks Is earnings power

https://www.youtube.com/watch?v=c6COwJk9as4
sufficient to provide a
margin of safety?
|
Professional journey: going through 6 equity market bubbles

MSCI AC Asia Pacific ex Japan Index
???
Bubble
MSCI AC Asia Pacific ex Japan China Euro
MSCI ACWI Bubble Bubble
400 MSCI ACWI IMI
387.76
Subprime
Bubble
300
219.94
200 208.14
TMT
Bubble
Asia
Bubble
100
50
Dec 97 Mar 99 Jun 00 Sep 01 Dec 02 Mar 04 Jun 05 Sep 06 Dec 07 Mar 09 Jun 10 Sep 11 Dec 12
Principles of Equity Analysis – 1st Quarter 2014 | 4

Buffett’s performance is outstanding and among the best among all

equity mutual funds that have existed for at least 30 years
Distribution of annualized Information Ratios of actively managed equity funds with 30+ years of return history
12
10
6 Buffett
0.53
0.00
0.05
0.10
0.16
0.21
0.26
0.32
0.37
0.43
0.48
0.59
0.64
0.68
0.73
-0.76
-0.11
-0.97
-0.92
-0.86
-0.81
-0.70
-0.65
-0.60
-0.54
-0.49
-0.43
-0.38
-0.33
-0.27
-0.22
-0.17
-0.06

Performance of Buffett and systematic Buffett-style portfolio also exceeds

that of adjusted market returns
Cumulative return of Berkshire Hathaway, systematic Buffett-mimicking portfolio, and value weighted
market return (leveraged to the same volatility as Berkshire)
$100,000.00
Berkshire Hathaway
Buffett-Style Portfolio
Overall stock market (leveraged to same vol.)

$10,000.00
$1,000.00
Cumulative Return (log scale)
$100.00
$10.00
$1.00
Oct-10
Oct-83
Oct-98
Oct-76
Oct-77
Oct-78
Oct-79
Oct-80
Oct-81
Oct-82
Oct-84
Oct-85
Oct-86
Oct-87
Oct-88
Oct-89
Oct-90
Oct-91
Oct-92
Oct-93
Oct-94
Oct-95
Oct-96
Oct-97
Oct-99
Oct-00
Oct-01
Oct-02
Oct-03
Oct-04
Oct-05
Oct-06
Oct-07
Oct-08
Oct-09
$0.10
1 Buffett-style portfolios do not account for transaction costs and other costs and benefit from hindsight, their apparent outperformance should be discounted

Going Concern vs. Liquidation Value

Going-concern value: Firm will continue in its business activities
Firm will continue to sell its goods and services
Firm will use its assets for value maximization
Firm will access its optimal sources of financing
Liquidation value: Firm will be dissolved

Firm assets will be sold separately
Going-concern value > Liquidation value

Value added from asset synergy
Value added by managerial skills
Principles of Equity Analysis – 1st Quarter 2014 7

Intrinsic Value
Asset Value Given a

Complete Understanding of an Asset’s
Characteristics
“True” or “Real” Value
Not Always Equal

to Market Price

Asset Mispricing
Efficient Market Theory:
• Intrinsic value = Market price
VE – P = (VE – V) + (V – P)
• Sources of perceived mispricing

• Analyst error
• Market error

Equity valuation typically follows a 5-step process

• Top down forecast: move
• Assess industry and from macro-economic
competitive context forecast to industry,
• Assess company individual company and
Understand the 2
financial asset forecast
1 business
• Bottom-up forecast
performance Forecast
(financial reporting, company
quality of earnings) performance
Assume full
professional Superior valuation 3 Select
responsibility process • Absolute valuation
appropriate
valuation model model: specifies
intrinsic value estimate
of the asset
• Relative valuation
model: estimate value
relative to that of
5 another asset
4 Convert
Apply
valuation forecast into
conclusions valuation
• Apply valuation Input forecast into the
conclusions depending model(s) with regards for:
on the purpose of the • Sensitivity analysis
valuation • Situational adjustments

Industry Analysis: Porter’s 5 Forces

Industry Analysis: Porter’s 5 Forces

Industry Analysis: Competitive Analysis

Competitive Analysis: Cost Leadership

Competitive Analysis: Differentiation

Competitive Analysis: Differentiation

Issues in Financial Statement Analysis
Non-Numeric Analysis
Regression toward the Mean
Mature Firms vs. Start-Ups
Sources of Information
Quality of Earnings
Valuation Models
Absolute Valuation Relative Valuation

Models Models
• Price ratios
• Present value models • Price-to-earnings ratio
• Dividend discount models • Price-to-book-value ratio
• Free cash flow to equity • Price-to-cash-flow ratio
• Free cash flow to the firm • Enterprise value multiples
• Residual income
• Asset-based models
• Vanguard’s method: CAPE (cyclically adjusted PE ratio

Principles of Equity Analysis – 1 st Quarter 2014 18
https://youtu.be/utqHVSkS3Qo
Roadmap of your Journey through this course
Objectives Modules
• Develop a solid understanding of the • Intrinsic value and systematic
1 Understanding equity methodology and thought process process to estimate it and act
markets and concepts
of value and return involved in fundamental equity security on it
analysis • Equity return concepts
2 Understanding what • Identify and analyze industry and • Industry and company analysis
drives the performance competitive context, assess a company’s•
of a business/company financial and operating performance
Measuring the value • Estimate intrinsic value estimate of a • Dividend Discount valuation
3 creation of a business company and estimate its value relative • Free cash flow valuation
to that of other assets • Residual Income Valuation
• Relative valuation
• Private company valuation
4 Getting rich! • Come up with investment • Group Project

recommendations/strategies that
works!

Uses of Equity Valuation
Stock Selection • Is the stock under- or overvalued?
Inferring Market • What does the security price say about

Expectations expectations?
Evaluating • What is the effect on firm value from a

Corporate Events merger?
Fairness Opinions • Is the value paid for the firm fair?

Uses of Equity Valuation (Continued)
Evaluating Business • What is the effect on firm value of a

Strategies new strategy?
Communicating with
Analysts and Shareholders • How is firm value being affected?
Appraising Private
Businesses • What is the value of a private firm?
• What is the value of equity

Compensation
compensation?
(Not tested after this slide for this lecture)
A Big Picture!
• How Capital Markets Function

• Importance of Global markets
• Macro Analysis
• Industry & competitive and Company Analysis

• Forecasting Company Performance
• Appropriate Valuation Model
• Using Forecasts to Estimate Firm Value
• Applying the Valuation Conclusions

How Capital Markets Function

“The Global 500 Matrix.”

Correlation: World vs Developed Market

Correlation: World vs Emerging Markets

Outlines
• How Capital Markets Function

• Importance of Global markets
• Macro Analysis
• Industry & competitive and Company Analysis

• Forecasting Company Performance
• Appropriate Valuation Model
• Using Forecasts to Estimate Firm Value
• Applying the Valuation Conclusions

Macro Forces
Major Trends and Developments
Donald Trump
Joe Biden


1-30
TRUMP Economic Policies

Interest Rate Shock & Stock markets

One Belt, One Road

China Economic Growth

… and the Indian

Impact of Technology and Innovation

Impact of Technology and Innovation

Basis for all valuation approaches

The use of valuation models in investment decisions (i.e., in decisions on which assets are
under valued and which are over valued) are based upon a perception that markets are
inefficient and make mistakes in assessing value an assumption about how and when these
inefficiencies will get corrected.
In an efficient market, the market price is the best estimate of value. The purpose of any
valuation model is then the justification of this value. (But this is not the case in the real
world!)

Misconceptions about Valuation (Not tested. Just for fun!)

Myth 1: A valuation is an objective search for “true” value
Truth 1.1: All valuations are biased. The only questions are “how much” and in
which direction.
Truth 1.2: The direction and magnitude of the bias in your valuation is directly
proportional to who pays you and how much you are paid.
Myth 2: A good valuation provides a precise estimate of value

Truth 2.1: There are no precise valuations. (Nothing is perfect!)
Truth 2.2: The payoff to valuation is greatest when valuation is least precise.
Myth 3: The more quantitative a model, the better the valuation

Truth 3.1: One’s understanding of a valuation model is inversely proportional
to the number of inputs required for the model.
Truth 3.2: Simpler valuation models do much better than complex ones.

Tu Lect1 Intro New

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Tu Lect1 Intro New

Uploaded by

Copyright:

Available Formats

ANALYSIS OF

Define Valuation and

Why we analyze Equity Securities? --

“Only 3 ways to get rich” – Fred Young

This course won’t

… investing always requires…

▪ Estimating intrinsic value independently of market price

• Undervalued stocks Is earnings power

Professional journey: going through 6 equity market bubbles

Principles of Equity Analysis – 1st Quarter 2014 | 4

Buffett’s performance is outstanding and among the best among all

Principles of Equity Analysis – 1st Quarter 2014 | 5

Performance of Buffett and systematic Buffett-style portfolio also exceeds

Overall stock market (leveraged to same vol.)

Principles of Equity Analysis – 1st Quarter 2014 | 6

Going Concern vs. Liquidation Value

Liquidation value: Firm will be dissolved

Going-concern value > Liquidation value

Principles of Equity Analysis – 1st Quarter 2014 7

Asset Value Given a

“True” or “Real” Value

Not Always Equal

Principles of Equity Analysis – 1st Quarter 2014 8

Efficient Market Theory:

• Intrinsic value = Market price

• Sources of perceived mispricing

Principles of Equity Analysis – 1st Quarter 2014 9

Equity valuation typically follows a 5-step process

Principles of Equity Analysis – 1st Quarter 2014 | 10

Industry Analysis: Porter’s 5 Forces

Principles of Equity Analysis – 1st Quarter 2014 11

Industry Analysis: Porter’s 5 Forces

Principles of Equity Analysis – 1st Quarter 2014 12

Industry Analysis: Competitive Analysis

Principles of Equity Analysis – 1st Quarter 2014 13

Competitive Analysis: Cost Leadership

Principles of Equity Analysis – 1st Quarter 2014 14

Competitive Analysis: Differentiation

Principles of Equity Analysis – 1st Quarter 2014 15

Competitive Analysis: Differentiation

Principles of Equity Analysis – 1st Quarter 2014 16

Issues in Financial Statement Analysis

Regression toward the Mean

Mature Firms vs. Start-Ups

Absolute Valuation Relative Valuation

• Vanguard’s method: CAPE (cyclically adjusted PE ratio

Roadmap of your Journey through this course

4 Getting rich! • Come up with investment • Group Project

Principles of Equity Analysis – 1st Quarter 2014 | 19

Uses of Equity Valuation

Stock Selection • Is the stock under- or overvalued?

Inferring Market • What does the security price say about

Evaluating • What is the effect on firm value from a

Fairness Opinions • Is the value paid for the firm fair?

Uses of Equity Valuation (Continued)

Evaluating Business • What is the effect on firm value of a

• What is the value of equity

(Not tested after this slide for this lecture)

• How Capital Markets Function

• Industry & competitive and Company Analysis

Principles of Equity Analysis – 1st Quarter 2014 22

How Capital Markets Function