Over Valuation

•Stock sells for more than its intrinsic value

•Intrinsic value is basically an estimation of what the

stock is truly worth

Indicators of over valuation

•P/E ratio(price index divide by stock market)
•Market cap of corporate equities divide by nation’s GDP
•Returns you get in market Vs others assets
•The inverse of P/E ration which is stock earnings divide
by price index

• ,
• Empirical evidence suggests that stock markets are
semi-strong efficient
• Equity prices reflect all publicly available information
• If the market doesn’t fully understand the
information available
• Overestimate the potential returns and so
overvalue the equity
• The price of overvalued equity may not be corrected
by the market if
• The data provided by managers is deliberately
misleading
• Collusion by gatekeepers including investment
and commercial banks, and audit and law firms
(Enron and World com amongst others).
Problems of overvaluation
A share is overvalued if it is trading at a price that
is higher than its underlying value
In an efficient market this can still occur if:
•The market doesn’t properly understand the
business
•The managers running the company do not convey
full company information honestly and accurately
•The price has been inflated to an extreme point,
expectations are higher than ever
•Bubble is caused when the price of a stock is
increasing and increasing without any real
arguments to justify the price increase
 
Management responses to overvaluation
Managers may be reluctant to correct the markets’
mistaken perceptions.
Which Leads to
•The use of creative accounting to produce the results
the city is expecting
•Poor business decisions aimed at giving the
impression of success
•‘poor’ acquisitions made using inflated equity to
finance the purchase
Even where shares are fairly priced shares
•Managers may hide the inherent uncertainty in the business
•Delaying Expenses and bringing forward revenue recognition
If equity remains overpriced, the company will not be able to
deliver – except by pure luck
If Management of overvalued company is unwilling to accept
the pain of a stock market correction,
• Earnings smoothing can escalate into false accounting
and outright lying
• Projects that give the appearance of potential earnings
may be adopted even where the true likely outcome is a
negative NPV
Research has also shown that companies are more likely to
make acquisitions when their shares are overvalued.
• To use the shares to buy assets (which have true worth)
• These mergers often do not make good business sense
and can destroy the core value of the firm
• The financial data the managers supply should be treated
with caution .i.e. manipulation of earnings
Case study
At the time of Enron’s peak market value of $60 billion, the
company was worth about 70 times its earnings and 6 times its
book value of assets.
The company was a major innovator, and the business had a viable
future. However, senior managers were unwilling to see the excess
valuation diminished. Rather than communicate honestly with the
market to reduce its expectations, they tried to hide the
overvaluation by manipulating the financial statements and
exaggerating the value of new ventures. By the time the market
had realised the extent of the problem, the core value of the
company had been destroyed.
Implications for valuations

In valuing a company, reported results form an

essential core of data since

• Reported earnings may be manipulated to produce

more favourable results (Aggressive Accounting)
• Financial statements should be scrutinised and
restated as necessary before being used as the basis for any
valuation
• The financial data they supply should be treated
with caution
The detailed techniques to be used for valuation
• Calculating the Cash to Operating Profit (COP) ratio. This
involves comparing EBITDA (Earnings before Interest, Tax,
Depreciation and Amortisation) with operating cash flow – they
should be about equal.
• Adjusting for changes in:
– depreciation/amortization policy
– bad debt provisions
• Considering whether the amortization of intangibles and R&D is
appropriate and adjusting if necessary
• Making changes if necessary to the way leases and hire purchase
agreements have been accounted for:
– Removing any exceptional items
– Removing any exceptional payments such as directors’
severance payments
High Growth Start-ups
A start-up business that wishes to attract equity
investment will need to put a value on the business
Valuing start-up businesses presents a different challenge
from valuing an existing business,
Because unlike well-established firms many start-ups have:
• Little or no track record
• On-going losses
• Few concrete revenues
• Unknown or untested products
• Little market presence.
• Inexperienced managers with unrealistic expectations of
future profitability
• Lack of past data makes prediction of future cash flows
extremely difficult.
• Any mathematical valuation will inevitably be only an early
starting point in the negotiations.
Estimating Growth
[

Growth for a start-up can be estimated based on

• Industry projections from securities analysts
• Qualitative evaluation of the company’s management,
marketing strengths and level of investment.
Both of the above ways are essentially subjective and are
unlikely to be reliable since
• High-growth start-ups usually cannot fund operating expenses and
investment needs out of revenues
• Long-term financial projections will be essential
Growth in operating income is a function of
• Management’s investment decisions
• How much a company reinvests
• The effectiveness of the investment in achieving
results
• The markets acceptance of the product and the action
of competitors
• Management's skills
• The riskiness of the industry.
Valuation Methods
• Estimate of growth is so unpredictable and initial high
growth stagnate or decline
• Valuation methods that rely on growth estimates are
of little value
• Cash is key indicator of start-up success and asset
models are therefore an important starting point
• However, they cannot provide an accurate value, since
value rests more on potential than on the assets in
place
• DCF models are problematic because of the non-linear
and unpredictable performance often exhibited in the
early years, rendering the estimates highly
speculative.
• Market based models are difficult to apply because of
the problem of finding similar companies to provide a
basis for comparison.