B294: Financial Analysis and Decision

Making

(Unit 5) – Session 1
Unit 5 structure
This unit is divided into three sessions, each lasting one week.

Session 1: Valuation of bonds and net asset value approach to equity pricing
• Valuation of fixed coupon bonds
• Net Asset Value (NAV) approach

Session 2: Dividend discount models and relative valuation techniques

• Dividend discount models and Gordon growth formula
• Relative valuation approach (also known as market multiples)

Session 3: Cash flow approach and real estate valuation

• Discounted Cash Flow (DCF) valuation method
• Relative valuation of real estate
• DCF approach to real estate valuation
2
Session 1

Valuation of bonds and net asset value approach to equity

pricing
What is Fundamental Value
•By quantifying the benefits of owning of a particular asset, these models aim to indicate an
accurate, justifiable price. This price is referred to as the intrinsic or fundamental value
(these terms can be used interchangeably). The calculations based on these models should
guide your investment decisions.

•More specifically, the recommended decision rule would be:

 if the fundamental value is greater than the market price, then you should buy the
asset
 if the fundamental value is less than the market price, then you should refrain from
purchasing it or, if you are currently in possession of that asset, then you should
swiftly sell it.
Trading and pricing bonds

• Bonds are tradable securities that are issued by those who

seek to borrow directly from the financial markets rather than
from banks.

• An issuer will sell bonds to investors in order to raise

finance. In return for the money obtained, the issuer
becomes contractually obliged to make periodic coupon
payments to the bondholders and to pay face value (also
called par value) on the maturity date, which is defined as
the date of the last payment.
The risks associated with investing in bonds

•There are three types of risk exposure that bond investors need to be aware of:
 Default risk captures the possibility that the issuer will go bankrupt and will be unable to make good on the
contractual payments. Lenders take default risk into account when deciding whether to make a loan
and in how they determine your interest rate. default risk can change as a result of broader
economic forces as well as changes in that particular company's financial situation. An economic
recession, for example, can impact the revenues and earnings of many companies, influencing their
ability to make interest payments on their debt and, ultimately, to repay the debt entirely.
 Liquidity risk arises because it may prove impossible for you to hold the bond until its maturity date. Your life
circumstances may force you to liquidate your bond sooner than anticipated by selling it in the market. However, at
time 0 when you buy the bonds, you are unable to accurately predict what the future sale price will be. This means
that if bonds are not kept until their redemption, the value of future cash flows will be uncertain.
 Reinvestment risk relates to the fact that you do not know the interest rate at which the coupons could be
reinvested. Imagine that your investment horizon is equal exactly to the maturity of the bond. Since most of the
coupon payments are received prior to the maturity date, you will want to reinvest them in order to earn additional
interest. Generally speaking, this reinvestment interest rate is going to be unknown ahead of time.
The valuation of bonds

• The fundamental value of a fixed coupon bond can be found by discounting the future cash flows at a suitable
discount rate. Since the cash flows to the bondholder are contractually predetermined, the formula is
straightforward:

•where:
 r is the risk-adjusted discount rate
 t1 is the time until the first coupon payment
 t2 is the time until the second coupon payment and so on
 T denotes time until maturity.

•(Time is measured in years or, whenever appropriate, fractions of a year.)

•
The valuation of bonds

•The only uncertain input into this equation is the risk-adjusted discount rate r. To
approximate this value, one of two methods may be used.

•The first method involves using the yield to maturity on bonds with similar credit rating and
denominated in the same currency.

•Yield to maturity is reported in all major financial newspapers and measures the total return
on a bond if it is bought immediately and held until the maturity date.

•Alternatively, r can be estimated as the sum of the risk-free rate and the risk premium:

• r = Rf + risk premium
•
The valuation of bonds - Example

• A bond issued by an American company pays $40 coupons semi-annually and has exactly
two years to maturity. Its face value is $1,000 and the credit rating of the issuer is BBB. An
average yield to maturity on BBB bonds with comparable maturity is 4%.

•What would be fair price for this particular bond?

The valuation of bonds - Example

•The first stage is to calculate the cash flows. The cash flows from the bond are listed in the table below.

Time to cash flow (in years) Cash flow

0.5 $40

1 $40

1.5 $40

2 $1000 + $40
•The second stage of the calculation is to insert the figures into the formula:

•Therefore, the fundamental value of this particular bond is $1,076.94

Fundamental analysis of stocks

•Fundamental Analysis focuses on finding the true value of a company by considering its future growth
potential and risk characteristics, as well as cash flows and dividends that are likely to be generated.

• Company valuation is central to fundamental analysis, because it assumes that markets can make
mistakes in the short-to-medium term.

•In other words, stock prices could deviate from their true (or fundamental value), which would be
indicative of over- or undervaluation. If these deviations are identified and investment decisions are
made accordingly, then trading profits will follow.

•Whenever the fundamental (intrinsic) value exceeds the stock price, the company is a good buy. If the
reverse is true, then the outlook will be rather bleak and price drops should be anticipated.
Fundamental analysis of stocks - Illustration

•Picture a profitable company with a competent management team, reasonable strategy and a
sound reputation. Everyone in the market agrees that the future of the company looks bright. In fact,
some investors became overoptimistic about the prospects of this company and pay astronomical
prices for its shares.

•Since the market price substantially exceeds its intrinsic value, investing in it would be a poor
decision. So, a good company is not always synonymous with a good investment. Sometimes huge
returns can be earned on firms that have managed to avoid bankruptcy by striking a deal with their
creditors.

•The stock price that was previously close to zero is likely to rebound vigorously after the deal, as
the company can now be regarded as a going concern. Astute investors may be able to benefit from
such rapid price increases, as long as they can predict correctly that the deal will indeed be struck.
Stock valuation

•There are several approaches to pricing stocks. The four most prevalent are:
 Net asset value approach
 Dividend valuation model
 Relative valuation techniques
 Discounted cash flow valuation.
Stock valuation

 Each valuation framework is associated with a specific pricing equation. The

equations rely on inputs that are not known in advance and since there is no
dependable way to foretell the future, your valuation will be only as good as your
guesses regarding these inputs.
 Knowing the formulas does not necessarily give you an edge when investing in
stocks, as many of the other market participants are also familiar with these pricing
models.
 It is ultimately an intimate knowledge of the company that will assist you with coming
up with reliable predictions and beating the market.
 A dependable valuation is a product of both analytical and detective skills.
Efficient market hypothesis

•Research indicates that stock markets digest relevant information quickly.

•For instance, Patell and Wolfson (1984) document that information contained in earnings
and dividend announcements issued by companies is reflected in the stock prices within the
first 30 minutes of its publication. After this period, the news becomes stale and it is
impossible to trade on it profitably.

•Fama (1970) formulated the efficient market hypothesis (EMH) stating that, at each point in
time, stock prices accurately reflect all available information.

•This hypothesis has profound implications for those trading in the market; if it were true, then
it would be impossible for investors to earn extra profits from gathering and analysing
information.
Efficient market hypothesis

•There are three different forms of the EMH and each form varies in the strength of the
assertions that are made.

•1. Weak form EMH

•The weak form of the EMH states that data on historical asset prices and trading volume
cannot help an investor to beat the market.

•The only information you have is the current positioning of the current stock price.

•The weak form of the hypothesis invalidates the usefulness of technical analysis which
deduces price trends and looks for some repetitive patterns in price trajectories to make
predictions about the future.
Efficient market hypothesis

2. Semi-strong form EMH

• The semi-strong form of the EMH makes a somewhat bolder claim, namely that all of the
publicly available information is instantly reflected in asset prices.

• This information set is very broad, including all macroeconomic and industry-level news,
existing corporate disclosures, and political, legislative and demographic developments, as
well as price history.

• If the semi-strong version is true, then collecting and analysing publicly available data
would not improve investment performance. This, in turn, would imply that fundamental
analysis is a pointless exercise.
Efficient market hypothesis

3. Strong form EMH

•The form of the hypothesis claims that all public and private information is already
discounted in stock prices.

•The consideration of the public information creates an overlap between the semi-strong and
strong forms.

•The difference emerges due to the inclusion of private information, which is available only to
a small group of corporate insiders that occupy top positions in the company that has issued
the shares. Clearly, these people have a better understanding of where the company stands
and where it is going.
Introduction to the net asset value (NAV) approach

• Balance sheet, which is a statement of a company’s financial position. It provides

information about the accounting value of assets that the company owns and details the
sources of funding that were used to purchase these assets.

• The three most important figures reported on the balance sheet are the total assets, total
liabilities and stockholders’ equity.
Introduction to the net asset value (NAV) approach

• Total assets represent an accounting estimate of the value of the firm’s possessions.
These could include, among others, property, plant and equipment, cash and liquid
investments, inventory, certain types of intangible assets, or accounts receivable (that is,
money owed to the company by its debtors and clients).
• Total liabilities capture all obligations of the company to other parties. Such obligations
arise primarily from different forms of borrowing or trade credit. Liabilities may include items
such as bank loans, accounts payable, outstanding bonds issued by the company,
customer deposits or wages and taxes payable.
• Stockholders’ equity is the capital that the shareholders have contributed into the
business and is typically referred to as the book value of the company. Two main sources of
equity are funds invested by the owners and earnings that have been retained in the
business, rather than paid out as dividends.
Introduction to the net asset value (NAV) approach

•The basic accounting equation states that the following relationship should always hold:

•Total assets = Total liabilities + Stockholders’ equity

•The left-hand side of the equation is the accounting value of the assets that the company
owns, while the right-hand side shows how the purchase of these assets has been financed.

•Firstly, the stockholders’ equity represents the value of the company according to accounting
conventions. Imagine that the firm sold all of its assets and repaid all of its liabilities. This
would leave stockholders’ equity as the remaining residual component that could be
distributed among the shareholders:
•Total assets − Total liabilities = Stockholders’ equity
Introduction to the net asset value (NAV) approach

•Considering the equation above, it becomes clear why the stockholders’ equity is sometimes
referred to as the net asset value.

• It is important to note that the stockholders’ equity does not have to be equal to the market value
of the company (also known as the market capitalisation).

• Market value is calculated as the number of shares outstanding (all shares issued by the
company) multiplied by the stock price. In other words, market value captures the worth of all
shares and tells us how much investors are willing to pay for the company at any given moment.

• Investors’ valuations may differ from those of the accountants. This is because the accounting
process does not capture all complexities of the real world, which leaves some room for
interpretation of the company value.
Calculating net asset value

•The value of a firm could be viewed as an aggregation of its assets

less its liabilities. Since the balance sheets records all the assets held
by the company, as well as all of its financial obligations, it could be a
helpful guide for calculating the company’s fundamental value. To
obtain a fundamental value of a single share, you would have to scale
the firm’s value by the number of shares outstanding:
Calculating net asset value - Example

•Using the preliminary financial figures for the fiscal year ending 23/02/2019 for Tesco Plc,
Total assets £49.047 billion

Total liabilities £34.213 billion

Number of shares outstanding 9.686 billion

•Calculate the net asset value per share.

•The stock price of Tesco at the end of fiscal year was £2.228. According to your NAV valuation, is this a good company
to buy?

•No, In this case, the stock price of £2.228 exceeds the fundamental value of £1.531 indicated by your NAV calculation.
This suggests that the shares of Tesco Plc may be overpriced and purchasing them would not be advisable.
Weaknesses of the NAV approach

•There are several reasons why the NAV method may produce inaccurate valuation:

•1. Problems with financial reporting

•Financial accounts report historical figures and are, by their very nature, backward-looking. However,
investors are interested in looking ahead at the prospects of the company and the amount of money that
could be generated in the future.

•The validity of the NAV approach can be undermined by inaccurate financial reporting. Balance sheet
entries may be estimated subjectively, or even cynically manipulated.

•Some liabilities that may endanger the very existence of the company may not be accurately reflected in
financial statements. For instance, a pending class-action lawsuit against the firm or likely future fines
arising from evident environmental pollution may be ignored by accountants.
Weaknesses of the NAV approach

• 2. Valuation of assets

• Quite often the value of land and buildings reported in financial statement reflects the historical
purchase price, rather than the current market value. The size of this discrepancy will depend on the
accounting standards adopted in a given country and the length of time that has elapsed since the
purchase.

• The value of machinery on the balance sheet is expressed as the purchase price minus depreciation.
The depreciation amount is determined by a mathematical formula, which has nothing to do with the
actual wear and tear of a particular asset. This means that an unused machine can have the same
value on the balance sheet as one that is worse for wear.
Weaknesses of the NAV approach

• 3. Accounting intangibles

• Investors are able to recognise the value of certain intangible assets, which may be ignored by
accountants.

• For instance, the skill set and morale of the workforce, good relationships with suppliers, customer
loyalty and satisfaction do not necessarily appear on the balance sheet.

• Reputation is another example of an intangible asset that is unlikely to be measured precisely by

accountants.

• Generally speaking, it is those intangibles that, in conjunction with fixed assets, produce an income
stream for the company.
Strengths of the NAV approach

• To start with, the valuation can be performed extremely quickly without the need to generate many
projections or to make simplifying assumptions.

• Additionally, the method may produce accurate estimates of the fundamental value in the following cases:
 For companies that hold predominantly tangible assets, the book value may be a true reflection of
their real worth.
 As long as the bookkeeping is reasonably accurate, the NAV estimate should be close to the
liquidation value of the company.
 Therefore, the NAV method could be applied to firms in financial difficulty where you would be
primarily interested in the break-up value. Intangible assets such as relationship capital, reputation or
expertise of the workforce will perish in the bankruptcy process. As a result, the only thing that matters
is the assets recorded on the balance sheet.
Strengths of the NAV approach

• NAV is particularly helpful when considering investment trusts and mutual funds. These investment
vehicles pool money from interested parties and use the funds to purchase stocks. Their worth will
depend on the value of the underlying stock portfolio, which can be easily computed using current
market prices.

• NAV plays a prominent role in takeover bids. Typically, shareholders of the target company would be
reluctant to sell their stocks for less than the NAV. A standard tactic in takeover bids is to revalue the
assets on the balance sheet in order to encourage a higher price.