FINC3015 - Notes
Week 1: Introduction to Valuations PRICE vs VALUE
Price is not the same as Value
- Value (of financial assets) derives from three factors:
cash flows which the asset generates for the buyer
growth in those cash flows
quality and risk of growth discount cash flows accounts for opportunity cost and risk - Price evolves in an ‘open market’ environment.
Price is transaction based depends on Supply and Demand
Example: $50 Australian note - VALUE DRIVERS:
Cash flow from asset
Growth in cash flows important for assets that don’t generate cash flows now
Quality of Growth risk of growth and opportunity cost - PRICE DETERMINANTS:
Order imbalance = Imbalance between supply and demand quick changes in price
Market moods and momentum moods/views in market change all the time
Narratives sold as “facts” investors don’t know when businesses lie about growth prospects
Liquidity or “illiquidity” more liquid asset = more likely its price is close to intrinsic value 1. Investors price in illiquidity (long time before they can sell asset) so price = intrinsic
value + illiquidity premium
2. Illiquid assets don’t trade frequently market price is outdated and does not reflect changes in intrinsic value
Financial Markets and Prices
Financial (and other) markets price value.
- Markets give us an estimate of exchange value (what we can exchange that asset for)
If markets are efficient price reflects underlying value
Efficient Market Hypothesis financial markets are efficient – outperforming market averages is futile
Market efficiency is driven by type of asset traded, type of market the asset trades in, scarcity of the asset, types of traders in that market etc...
Market efficiency = traders have good knowledge of type of asset traded, amount of cash flows asset will generate, behave rationally and no market imperfections hard to achieve
o Therefore, distortions between price and value can continue over the long-term.
Market Inefficiency – Investors do not behave “rationally”:
- Price clustering tendency of prices to be observed more frequently at some numbers than others
- Unconscious herding behaviour most investors follow the advice and investment choices of other investors, creating a herding behaviour likely leads to crisis (e.g., GFC, dot com crisis)
Prechter (2001) found that people invest more money in rising markets (rising share price) and less money in falling markets (falling share price)
o This reduces the chances of earning profits.
o Prechter found this was the case for both general public and institutional investors o Institutional investors often have no choice, and must follow what the public want to
invest in or else they lose funds and clients
Julian Robertson famous fund manager of Tiger Management Prechter (2001) achieved annual gains of ~30% for nearly 2 decades by buying the best stocks, shorting the worst
o Tiger refused to invest in internet stocks during the internet stock boom period
o Tiger was correct everyone buying internet stocks would drive price well above intrinsic value causing price to crash soon
o Tiger reduced its investment in technology stock to zero during boom period investors pulled their money out of Tiger
o Tiger lost management fees – had to sell stocks to recover capital – fund later closed down as lost all clients
- Market Noise and Incentives Snapchat case study
Morgan Stanley was the underwriter in Snapchat’s IPO they had very optimistic price targets for Snapchat (much higher than market share price)
After issuing a report that Snapchat’s earnings had been overestimated by $5b over a 5-year horizon price target remained unchanged
Morgan Stanley has an incentive to overestimate Snapchat’s share prices an underwriter wants high company shares so they don’t have to support (buy) shares in the secondary market
- Market Noise and Incentives Snapchat case study
Morgan Stanley was the underwriter in Snapchat’s IPO they had very optimistic price targets for Snapchat (much higher than market share price)
After issuing a report that Snapchat’s earnings had been overestimated by $5b over a 5-year horizon price target remained unchanged
Morgan Stanley has an incentive to overestimate Snapchat’s share prices an underwriter wants high company shares so they don’t have to support (buy) shares in the secondary market
Market Microstructure (Exchange Mechanisms)
Exchange mechanisms (Market Microstructure) themselves can lead to mispricing and prevent the price from reaching intrinsic value (sometimes for a relatively long period of time)
Limit order book impact on price
- Limit order book impacts share price as the current price is equal to the last traded price No. of
orders Bid Quantity
Bid Price
Ask Price
Ask Quantity
No. of orders 15 11384539 0.003 0.004 9140130 12 11 13204056 0.002 0.005 2824350 4 3 5650004 0.001 0.006 1500000 2 0.007 300000 1 0.008 336667 2 0.009 1907781 1 0.010 2379995 1 0.015 2000000 1 0.018 99997 1 0.030 380000 1 - What is share price if 1,000,000 shares were:
(1) Market sell order, then (2) Marker buy order, then (3) Market sell order
- Solution:
(1) 1st trade – market sell order – at $0.003 (best bid price) (2) 2nd trade – market buy order – at $0.004 (best offer price)
+33.33% increase in price
(3) 3rd trade – market sell order – at $0.003 (best bid price) -25% decline in price
- This is the bid-ask bounce
Small share price leads to large % price changes
Effect of minimum price increments
- Minimum increments are maintained to prevent orders purely just to get on top of the bid/ask column (e.g., $0.00300000000001)
- ASX minimum price increments (tick sizes) at present:
Price range Price step No. of equity securities
No. of equity securities (%)
$0.001 - $0.099 $0.001 832 43.9%
$0.100 - $1.995 $0.005 807 42.6%
$2.000 -
$99,999,990
$0.010 255 13.5%
- In prior example: bid-ask spread ($0.004 – $0.003 = $0.001) permitted by ASX
But $0.0035 can’t be placed
But analysts may accurately predict intrinsic value to be $0.0035 due to minimum price increments, intrinsic value will not be equal to price
Government controls
- Chinese stock market – price can only move by max 10% (for price stability)
- This can lead to severe mispricing – a company might announce immense fall in expected earnings – intrinsic value falls by 80% it will be overpriced for at least 7 days
INTRODUCTION TO VALUATION Purpose of Valuation
To make sense out of uncertainty and drive price closer towards intrinsic value Applications of Valuation – Valuation is used for:
Stock/Asset selection
- Which asset is over/under priced?
- Buy or sell?
- Markets are not always “efficient” – there are times of irrationality + anomalies leading to market mispricing
- Ben Graham investors should take advantage of anomalies (whereby a market may be too optimistic or pessimistic)
Inferring market expectations
- Prices tell us what the market expects a company’s future cash flows and performance to be - Reverse price calculation to understand market expectation
Evaluating corporate events
- E.g., company takeover we want to evaluate the effect of the takeover on the firm’s future cash flow, and hence intrinsic value
Rendering fairness opinions
- E.g., takeover of another firm – need to place a value on the firm to pay fair price for it - So that its fair for both sides
Evaluating business strategies and models
- Valuation can evaluate the effect of new business strategies on the company’s future performance and earnings – on its intrinsic value – and on its shareholder’s wealth
Communicating with analysts and shareholders
- Valuation helps us communicate to analysts and shareholders what we believe the effect of certain events/business strategies will have on the company’s value
Appraising private business
- Valuation to figure out a price that you would be willing to buy a business – for which there is no current market price to reference
Valuation Formula
1) Understand the Business - Involves two elements:
1) Industry and competitive analysis the competitive environment and industry it operates in 2) Financial statement analysis its cash flow structure, financing structure etc.
- Must understand company’s economic + industry context and management strategic responses a. Economic context
o pro-cyclical (cash flows move in the same direction as the economic) OR
o counter-cyclical (cash flows move in opposite direction as the economic cycle) – e.g.
insolvency businesses b. Industry factors
o e.g., Qantas airline industry factors = COVID-19, oil prices for aviation fuel o How attractive is the company’s industry?
o What is the company’s relative competitive position within the industry?
What is the company’s market share?
Is the company competitively weak, and thus prone to takeover? must incorporate takeover premium in the valuation
o What is the company’s competitive strategy?
o How well is the company executing its strategy?
c. Value drivers are:
o performance variables that impacts the results of a business if you change it, it will significantly impact valuation
o linked to shareholder value creation
o measured by financial KPIs and operational KPIs that cover long-term growth and operating performance
o Financial KPIs:
From financial statements
Example: sales, costs, investments, earnings growth, cash flow growth, ROI,
Is the company competitively weak, and thus prone to takeover? must incorporate takeover premium in the valuation
Miller et al. (2004) suggests profitability, growth, and capital intensity are key considerations in determining value drivers
o Operational KPIs:
not in financial statements – but can also be quantified
Example: production effectiveness, reputation, customer satisfaction (measured by surveys, research, customer loyalty program sign-ups…)
2) Forecasting Company Performance
- Includes forecasting sales, earnings, dividends and financial position (in the long and short term) - This involves economic forecasting and company specific forecasting
1. Economic Forecasting
o Top-down forecasting: start by forecasting entire economy’s economic growth and working your way down to forecasting the industry’s market size, and then company’s market share to arrive at revenue forecasts.
o Bottom-up forecasting: start by forecasting individual industry economic growth to arrive at a growth estimate for the entire economy
2. Financial Forecasting
o Involves forecasting the financial information of a specific company
o PRO-FORMA Analysis: integrate analysis of industry prospects & competitive corporate strategy with financial statement analysis (FSA) to form specific numerical forecasts
3) Selecting the Appropriate Valuation Model
- Select valuation model based on the company’s characteristics - DCF is good for large businesses
- But DCF not good for companies with greater uncertainty (e.g., Private businesses) other models more appropriate
- Use more than one model to grapple with the uncertainty 4) Using Forecasts in a Valuation
Issues in Financial Statement Analysis
Non-Numeric Analysis
- Some value drivers can’t be numerically forecasted
Regression toward the Mean
- Reverting numbers, and how we deal with that
Mature Firms vs Start-ups
- Depending on firm, we focus on different aspects of their financial statement - Growth more important for start-ups
- Stability of cash flow + market share more important for mature firms
Sources of Information
- Data is not perfect be cautious about inbuilt biases in data, and how data was calculated
Different companies use different accounting report methods
Data providers may also report different figures as they use their own formula to calculate company earnings (Bloomberg does this to eliminate issue of different company reporting methods)
Investors who don’t understand different values will have incorrect reaction + valuation
- Words are powerful e.g. earnings “rose” to $99,999 gives positive reaction, but earnings “fell” to $99,999 gives negative reaction
Quality of Earnings – Risk Factors
- How do we ensure the company’s earnings are sustainable?
- How much certainty do we have about the company’s earnings?
- If the company’s value drivers are mainly external factors which the company cannot control, then there is greater uncertainty about earnings.
- Other signs (risk factors) of poor quality of earnings:
Poor quality of accounting disclosures
Related-party transactions
Frequent management or director turnover
Pressure to make earnings targets
Auditor conflicts of interest or frequent turnover
Incentive compensation tied to stock price
External or internal pressures on profitability
Debt covenant pressures
Previous regulatory/reporting issues
- Big differences between tax income and reported income.
Week 3: Building Pro-Forma Statements [INTERNAL ENVIRONMENT]
BUILDING PRO-FORMA STATEMENTS Pro-forma Statements
A pro-forma statement is a prediction of how a firm’s financial statements will look in succeeding years.
- These statements are typically prepared by analysts in their process of valuing a company helps analysts go on to forecast cash flows to value the company
- Are constructed as an integrated model of the firm’s financial statements based on a view of the firm’s efficiency in the production and marketing of its products and/or services.
Firms can report pro-forma results which are hypothetical (non-GAAP) results based on certain characterisations a good analyst will (instead of relying on the firm’s own forecasts), will go back to the raw data and make their own pro-forma statement
By constructing pro-forma statements the financing needed under various assumptions of growth, operating ratios, financing ratios, and the sensitivity of the firm to changes in the business environment can be evaluated
- All these are linked together we want to understand how changes in one thing impacts others
A reliable valuation analysis requires a set of economically plausible and rational assumptions gathered from an understanding of the firm but also its operating environment.
The projections that form the basis of the pro-forma statement are likely to be based on:
- historical information, particularly the business’ historical financial statements - analyst expectations
- macro-economic announcements, - industry analysis
- and most importantly subjective business judgement.
Understanding the interaction of these factors will allow an analyst (or investor) to make informed and rational choices regarding the assumptions that will form the pro-forma model.
NOTE: valuation is an art, no a science every analyst will produce different valuation as everyone has different ways of interpreting events
- You will be accessed on the way you explain and justify your valuation Modelling Financial Statements
The reason we create a model of the financial statements is to reduce the work needed to construct projections.
- It would be a great deal of work to project each of the items on the income statement and balance sheet separately and independently.
We want to reduce our projections to a limited number of “drivers” and use projections of these drivers to fill in the financial statements.
We will assume that COGS, SGA, Cash, Inventory, Accounts Receivable, Net PPE, Accounts Payable, and accrued expenses vary with sales assume that Revenue is the key driver of other components e.g.
cost is a fixed % of sales, and when sales change, cost changes along with that - In the short run, SGA and Net PPE may not directly vary with sales.
Depreciation charges are set by the depreciation schedule and depend on Net PPE.
- Depreciation independent from sales, but dependent on Net PPE
Sales-Driven Approach to Forecasting
- Wherever possible (and reasonable) one should assume that the items in the balance sheet and income statement depend directly on the sales of the firm.
- While not all accounts in financial statements will be related to sales, this approach is based on the assumption that in the long run all a firm’s productive assets will be related to sales.
Think about a firm that has recently seen an increase in sales. When a firm’s sales increases, its expenses will also increase as a function of the production process; its assets will increase to support the increase in sales; and its liabilities will also increase to finance the expansion.
Ratio Analysis
- This is primarily done using ratio analysis in a two-step process.
The first step is to study and evaluate the firm’s past performance using financial ratios.
The second step is to predict future financial ratios. Often this is based on the assumption that past relationships will continue into the future.
- Remember that past performance is no guarantee of future performance.
Evaluate past performance
– what is reasonable to carry forward?
– what need to be slightly changed?
– what components need to be completely reforested, or not carried forward?
E.g., acquisition should not be carried forward it is an inorganic growth strategy, and we know (predict) that the firm will not repeatedly acquire new businesses only carry an acquisition forward if that company repeatedly acquires new businesses
Note: acquisition growth strategy is unsustainable in the long run for companies growing from acquisitions are highly susceptible to shocks do not value them as going concerns - By using ratios we construct a “sales driven model”
We do this because sales projections allow us to determine FCF.
Lifecycle of a Business
- Start-up = low sales, high investment, high costs
- Rapid growth = market is excited about new product, flock to buy it a new market emerges (e.g.
Apple created a market for smartphones) attracts more competitors to enter
- Maturity = firm is now well established, and their market is well established too growth begins to slow down and stablise due to competitors entering
- Decline = market is changing Rebirth = new product, new market etc. Death = end of business
- The length of these stages vary for each company maturity is particularly long for energy companies
- Stage of the business’ lifecycle is important for valuation e.g., rapid growth firm is approaching the end of the rapid growth phase project lower growth figures as the firm enters maturity - A company is an aggregate of all its different products value driver comes from the company’s
ability to manage the cycle of its products to maintain steady and high sales e.g., start product development in the old product’s maturity phase
Revenue Derivation
- In a sales-driven approach to building out the pro-forma, revenue affects most line items
Hence it is important to forecast revenue as accurately as possible errors in revenue forecast leads to errors almost everywhere else
There are a number of approaches that can be taken for this - Top-Down Analysis
This starts with an analysis of the general macro environment, then narrows to the company’s specific industry and then considers business-specific factors
Estimate the market size available for the business given various trends, and then how large a market share the company will be able to secure
Used for businesses that are impacted by external factors - Bottom-Up Analysis
This moves in the opposite direction to Top-Down analysis, forming projections based on granular forecasts for each product and building upwards
Used for businesses that are in a monopolistic market, and has more control over pricing in the marketplace
- Price x Quantity
Remember in your analysis that revenue is simply the price of units sold times the number of units sold i.e. Revenue = Price x Quantity
Think about how much control the company has over the price of its product, and the quantity that is sold
Both internal and external factors affecting these two key drivers should be analysed - Drivers of Revenue:
Price Drivers
Inflation: currently not a driver (as inflation so slow) but going forward, inflation may rise
Price Strategy: premium pricing strategy (high price) or low price-high quantity strategy
Regulation: level of regulation (e.g. energy company highly regulated in terms of price – must apply to government to increase price – more regulation = more stable price) low
regulation in consumer industry = unstable pricing, companies have more control Volume Drivers
Population: e.g. washing machine – people only need 1 per family, and only replace after 10 years so limits to how much you can sell
Economic growth: high economic growth = higher quantity sold
Competition: if the firm is in a highly saturated industry e.g. four big banks in Australia for home loans – each bank will find it difficult to increase their market share relative to the others – because market share already established
Free Cash Flows
- In financial valuation, the goal is ultimately to relate sales to free cash flow.
- We need to use ratios to relate the variables used to derive free cash flow from sales.
How are components of the income statement related to sales?
How are working capital requirements related to sales?
How is capital expenditure related to sales?
- There are many ratios that can be calculated.
Focus will be on efficiency and profitability ratios.
Ratios by themselves do not tell us much we are interested in the trend they follow, how it is compared to other firms (our firm may change their business strategy to become more similar to other firms in the future, so cross-sectional analysis is also important), and how it impacts or links to sales
- Depending on the context, different ratios may be used (e.g., an equity investor vs. a lender).
Financial Ratios
Profitability Ratios
Asset Management / Utilisation Ratios
Liquidity (Debt/Safety) Ratios
Cash Flow Ratios
Valuation Ratios
Tips for forecasting – Questions to keep in mind:
- Must interpret the economics of the firm’s future.
The forecasts need to make economic sense – is this forecast achievable and why?
Form assumptions that are reasonable, economically justifiable - What creates the growing financing need?
Need to identify the self-sustainable growth rate – at what stage is the company able to finance its organic growth strategy using its own operations and not relying on capital markets
- Is the firm retaining enough earnings to finance its growth in assets?
Sensitivity analysis of the key drivers
- How does one find the key drivers and assess their effects?
Ratios can tell us a lot about what the key drivers of our firms are as ratios change, what does that do to sales?
Ratio Analysis
The value of a firm is determined by its profitability and growth.
