Valuation - Investment Management - Lecture Slides, Slides of International Management

Download Valuation - Investment Management - Lecture Slides and more Slides International Management in PDF only on Docsity! Investment Management 2010 Session 6 Valuation Manuraj Jain Manuraj Jain 2 Internal liquidity ratios quick ratio recevable days inventory procesn days payable days cash conversion rate operating performance ratios total asset turnover operating profit ratio profitability ratios return on capital profitability asset turn over financial leverage return on equity(dupont) financial risks total debt ratio interest coverage trading turnover dividend growth potential •Clarity on ratios? •Submissions incomplete? •Calculations incorrect? •Excel with no calculations •Data taken from Money control •Understanding of ratios can be improved Manuraj Jain 5 • Those whose sales and earnings will be heavily influenced by aggregate business activity • Examples? • What ratios to look out for? Cyclical company •Those that will experience changes in their rates of return greater than changes in overall market rates of return •In CAPM terms these are stocks with higher beta Cyclical stocks
Growth stocks will have positive earnings surprises and above-average risk adjusted rates of return because the stocks are undervalued
Value stocks appear to be undervalued for reasons besides earnings growth potential
Value stocks usually have low P/E ratio or low ratios of price to book value Buy / Sell Compare with CMP Estimate intrinsic value Company Analysis to determine its characteristics
Porter’s 5 forces
SWOT
Structure-Conduct-Performance Models
Buffet’s Tenets
Lynch’s suggestions Manuraj Jain 7 Barriers to Entry Government Policy Economies of Scale Product Differentiation Capital Requirements Switching Costs Access to Distribution Channels Cost Disadvantages Independent of Scale Bargaining Power of Suppliers Threat of New Entrants Threat of New Entrants Suppliers exert power in the industry by: * Threatening to raise prices or to reduce quality Powerful suppliers can squeeze industry profitability if firms are unable to recover cost increases Suppliers are likely to be powerful if: Threat of Substitute Products Threat of New Entrants Threat of New Entrants Bargaining Power of Buyers Bargaining Power of Suppliers Products with similar function limit the prices firms can charge Keys to evaluate substitute products: Products with improving price/performance tradeoffs relative to present industry products Example: Electronic security systems in place of security guards Fax machines in place of overnight mail delivery Threat of Substitute Products Threat of New Entrants Threat of New Entrants Rivalry Among Competing Firms in Industry Bargaining Power of Buyers Bargaining Power of Suppliers
A. Present value of cash flows (PVCF)
1. Present value of free cash flow to equity (FCFE)
2. Present value of free cash flow to firm (FCFF)
3. Present value of dividends (DDM)
B. Relative valuation techniques
1. Price earnings ratio (P/E)
2. Price cash flow ratios (P/CF)
3. Price book value ratios (P/BV)
4. Price sales ratio (P/S) DCF is method determining the intrinsic value of a company using future cash flows adjusted for time value. Assumption:
that every asset has an intrinsic value that can be estimated based on cash flows, growth and risk. Requires:
Forecasted cash flows
Discount rate Firm Valuation: Value the entire business Assets Liabilities Existing Investments Fixed Claim on cash flows Generate cashflows today Assets in Place Debt Little or No role in management Includes long lived (fixed) and Fixed Maturity short-lived(working Tax Deductible capital) assets Growth Assets i Residual Claim on cash flows Significant Role in management Expected Value that will be created by future investments eo Perpetual Lives Equity valuation: Value just the equity claim in the business Manuraj Jain 22 
Critical ingredient. Errors in this can lead to incorrect valuations
Discount rate to be consistent with the riskiness of the cash flow and type of cash flow
Equity cash flows
Currency being used
Nominal versus real Manuraj Jain 30 Model CAPM APM Multi factor Proxy Expected Return Inputs Needed E(R) = R,+ 6 (R,,- Rp Riskfree Rate Beta relative to market portfolio Market Risk Premium E(R) = R-+ Diet B; (R- Ry) Riskfree Rate; # of Factors; Betas relative to each factor Factor risk premiums E(R) = R- + Zen B; (R- R,) Riskfree Rate; Macro factors Betas relative to macro factors Macro economic risk premiums E(R)=a+ Zi-1.N b Y; Proxies Regression coefficients Manuraj Jain 31 
APM is a multi factor model, unlike CAPM, but the factors are not specified. It holds that expected return can be represented as linear function. APM discussed more of explanatory than statistical asset returns. Unlike CAPM, APM does not reveal the source of priced factors.
Fama French Model
Burmeister, Roll and Ross (BIRR) Model
Risk free return (Rf)
Short term – approx. current inflation
Long term – matching the duration of a bond to the term of analysis
Not all govt securities are risk free
Market risk premium
The important issues in this calculation are historical period, market index, premium on arithmetic or geometric average, short or long term Rf ?
Beta
Sensitivity of stock’s return to market return. Estimated using the slope of regression line between stock and market. Regression beta, levered, bottom up, fundamental beta… ▪ Length of estimation period, considering the risk profile ▪ Appropriate return interval – daily, monthly, quarterly, etc. ▪ What market index? Beta of the stock = Covariance of stock with market portfolio/ Variance of the market portfolio The Indian government had 10-year Rupee bonds outstanding, with a yield to maturity of about 10.5% on January 1, 2009. In January 2009, the Indian government had a local currency sovereign rating of Ba3. The typical default spread (over a default free rate) for Baa3 rated country bonds in early 2009 was 2.5%. The riskfree rate in Indian Rupees is The yield to maturity on the 10-year bond (10.5%) The yield to maturity on the 10-year bond + Default spread (13%) The yield to maturity on the 10-year bond — Default spread (8%) None of the above Manuraj Jain 36  C start with the beta of the business that the firm is in ) y Adjust the business beta for the operating leverage of the firm to arrive at the unlevered beta for the firm. Y Use the financial leverage of the firm to estimate the equity beta for the firm Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (Debt/Equity)) Manuraj Jain 37 
Standard error in a bottom up beta is lower than a single regression beta
Bottom up beta can be adjusted to reflect changes in the firm business mix and financial leverage. Regression betas reflect the past
Bottom up betas can be estimated even with no historical data. IPOs,private businesses, division of companies Manuraj Jain 40 Regression Effective Fixed / variable Company Name Beta D/E Ratio tax rate % cost SAIL 1.28 0.5 0.28 Tulsyan 0.98 3.46 0.05 Uttam Galva 1.18 1.87 0.05 Tayo 0.85 0.99 0.30 Suntlag Iron & Steel 1.31 0.67 0.14 Shree Precoated Steel 1.25 241 0.07 Shivalik Bimetals O78 1.03 0.16 National Steel 1.09 0.97 0.03 Mukand Ltd 1.51 4.08 0.19 Monnet Ispat 1.28 1.6 0.18 Mahindera Usgine Steel 1.31 O71 013 Kalyani Steel Ld4 0.57 0.06 J 5 W Steel 1.16 13 0.20 Hisar Metal 1.16 49 0.03 Average (Simple) 1.16 1.77 9.75 0.13 Tata Steel 1.44 04 30.66 0.32 (Source: Prowess)  Cast of borrowing should be based upon (1) synthetic or actual bond rating (2) default spread Cost of Borrowing = Riskfree rate + Default spread Marginal tax rate, reflecting tax benefits of debt Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) “ (Debt/(Debt + Equity) ost of equity based upon bottom-up beta Weights should be market value weights Manuraj Jain 42 
Look at the historical growth in EPS
Look at what others are estimating
Analysts estimate growth in eps. Note that
Look at fundamentals
What is being reinvested and what are its returns? Manuraj Jain 45
A sustainable growth rate is needed for a long term approach of valuation. g = ROE*Retention Ratio
Expected growth rate cannot exceed ROE
Picking the correct ROE and RR depends on:
Should it be actual ratio based on last year’s financials
Or calculated over a business cycle, say 6-7 years
Or Arithmetic or geometric average of last 5 years
Treatment of this in an emerging economy or matured economy
The methods may include management estimate and analyst estimate.
Dividend sare paid out of earnings: ▪ Dividend = Earnings × Payout ratio
Payout ratios of dividend paying companies tend to be stable. ▪ Growth rate of dividend g = Growth rate of earnings
Earnings increase because companies invest. ▪ Net investment = Retained earnings
Growth rate of earnings is a function of: ▪ Retention ratio = 1 – Payout ratio ▪ Return on Retained Earnings g = (Return on Retained Earnings) × (Retention Ratio)