Security-Analysis-LEARN_MAT_Prelim01.docx

**[PRELIM]** Expected capital appreciation incorporates the investor's perspective on the convergence of market price to intrinsic value. Current f [ Investment environment] In our lifetime, we earn and spend money, however it is not unusual that our current money income balanced exactly with our...

**[PRELIM]** Expected capital appreciation incorporates the investor's perspective on the convergence of market price to intrinsic value. Current f [ 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. 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. 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 as legal and regulatory environment. C. What is the company's competitive strategy? 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. [3. Selecting the appropriate Valuation Model. ] 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 be 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. 1\. Consistent with the characteristics of the company being valued. [Value Perspectives] Value perspectives serve as the foundation for the variety of valuation models. The quality of the analysts 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 of 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 manager'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 alpha (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. A value of 1.0 means increased in wealth (positive returns). A value less than 1.0 means declined in wealth (negative returns). A value of 0 (zero) means all the money invested is lost. 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) Example of [positive returns]: Assume an investment that cost P 130 and is 250 worth after being held for two years. HPR= ending value of investment / beginning value of investment ex. 250/130 = 1.92 Annual HPR = 1.92^1/n^ = 1.92^1/2^ = 1.3856 Annual HPY = 1.3856 -- 1 =.3856 or 38.56 % Example of [negative returns (loss)]: HPR = Ending Value / beginning value = 300 / 400 =.75 HPY = 0.75 -- 1.0 = -.25 or -25% Example of a [multiple-year loss] over two years: Annual HPR =.857^1/n^ =.857^1/2^ =.9257 Annual HPY =.9257 -- 1 = -0.0743 or -7.43 % In contrast, consider an investment of 150 held for only six (6) months that earned 12% return. HPR = (150) (.12) = 18 + 150 = 168 / 150 = 1.12 (n =.05) Annual HPR = 1.12^1/.5^ = 1.12^2^ = 1.2544 Annual HPY = 1.2544 -1 = 0.2544 or 25.44% The assumptions in the example for the two-year investment, the annual yield is constant such that the 38.56 % each year rate of return, compounded. In the six months investment, the first six months rate of return is same as with the second six months such that the 12 percent rate of return for the initial six months compounds to 25.44 percent for the full year, however because of uncertainty in earning the same return in the next six months, institutions do not compound partial year return. Another point, the ending value of the investment can come from the positive or negative change in price for the investment (stock price from 10 to 12), income from investment alone, or from the combination of price change and income. The ending value of the investment includes the value of everything related to the investment. 5^th^ week [Historical Mean Rate of Returns (single investments)] A single investment can experience high rates of return during some year, or low rates of return, or negative returns. For each individual investment, each return can be analyzed or you may compute for summary returns that indicates investment's typical experiences or the rate of returns over extended period of time. Two summary measures of return performance for a set of annual rates of return HPYs for an individual investment. a. Arithmetic Mean (AM) = b. Geometric Mean (GM) Year Beginning value ending value HPR HPY 1 100 115 1.15 0.15 2 115 138.0 1.20 0.20 3 138 110.4 0.80 -0.20 AM= ∑HPY/n AM=.15+.20+-.20/3 =.15/3 =.05 or 5% GM= product of HPR^1/n^ - 1 =1.15 X 1.20 X 0.80 -- 1 =1.104^1/3^ -- 1 = 0.03353 or 3.353% GM is considered a superior measure of log-term mean rate of return. It indicates the compound annual rate of return based on the ending value of the investment versus its beginning value. Example: Compounding of 3.353 for three years (1.03353)^3^ = Compound interest = (1 + i)^n^ = (1+.03353)^3^ = 1.03353^3^ = 1.104 Year Beginning value ending value HPR HPY 1 50 100 2.00 1.00 2 100 50 0.50 -0.50 AM= ∑HPY/n AM= (1.00 + -.50)/2 =.50/2 =.25 or 25% GM= product of HPR^1/N^ - 1 = (2.00 X.50)^1/2^ -- 1 =1.00 -- 1 = 0% The 0 percent rate shows of no change in investment. If rates of returns are the same for all years, GM = AM. If rates of return vary over the years, GM is lower than AM. The difference between GM and AM depends on the yearly change in the rates of return. The volatility of the rates of return depends on the size of difference between the two means. Present Value = X / (1 + i)^n^ [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.