INV3701 STUDY NOTES: EQUITY ASSET VALUATION

INV3701 STUDY NOTES; EQUITY ASSET VALUATION STUDY UNIT 01: CHAPTER 1 & 2 EQUITY - Equity is what the shareholders own from an entity e.g. ordinary shares, preference shares & Retained earnings. JUSTIFY VALUATION Valuation is the estimation of an asset’s value based on: 1. Variables perceived to be closely related to future investment returns such as * interest rates * Price appreciation * Management 2. Comparison with closely similar assets * shares of similar companies * industry (benchmarking) DEFINE VALUE In simple terms value means or answers the question: How much is an asset worth looking into the future? a) INTRINSIC VALUE – The value of an asset given complete understanding of the asset’s investment characteristics, a number of factors are considered when calculating intrinsic value and these differ from investor to investor. b) MARKET PRICE – The value of an asset which is determined by the forces of demand and supply in the market (trading price of the asset) The difference between intrinsic value and market price is called mispricing, if MP > IV asset is overvalued, (mispriced) if MP < IV asset is undervalued (mispriced), if MP = IV asset is fairly valued. c) GOING CONCERN VALUE – The value of a company (intrinsic value) under a going concern assumption. Assumption: The company will continue its business activities into the foreseeable future *focus of the module d) LIQUIDATION VALUE- Value of a firm’s assets if it were to be dissolved and its assets sold individually *not as a unit USES OF VALUATION Stock selection – Investors need to value assets to be used in a portfolio, valuation helps to select assets that the investor desires. Extracting market expectations – When an asset is overvalued or undervalued we expect mispricing to be corrected (Price increase or decrease) Evaluating co-operate events – Companies ought to be valued pre and post certain corporate events such as: mergers and acquisitions Expression of fairness – Is the asset fairly valued? Overvalued or undervalued? Communication tool – Valuation acts as a communication tool for *management * Shareholders * Analysts Evaluation if business strategies and models – corporate strategies and business models determine the value placed on a company THE VALUATION PROCESS 1. UNDERSTANDING THE BUSINESS • Evaluate industry prospects – Economic and technological factors • Competitive position – Companies compete with each other for sales, what’s the company’s competitive advantage? • Corporate strategies – What does the firm intend to do? 2. FORECASTING COMPANY PERFOMANCE • Top down approach - Macro-Economic factors e.g. Exchange rates, inflation - Industry Forecasts – Economic & technology factors - Company Forecasts – Use financial statements • Bottom up approach - Macro-Economic factors e.g. Exchange rates, inflation - Industry Forecasts – Economic & technology factors - Company Forecasts – Use financial statements 3. SELECTING THE APPROPRIATE VALUATION MODEL a) ABSOLUTE VALUATION MODELS – These models specify the intrinsic value of an asset, they are also called present value models * Dividend discount valuation models * Residual income model * FCFF and FCFE b) RELATIVE VALUATION MODELS – The models compare values of similar assets (benchmarking) * Price multiples * Enterprise value multiples 4. CONVERTING FORECASTS INTO A VALUATION MODEL - The forecasted fundamentals (inputs to the model) are used to calculate the intrinsic value. *Dividends forecast – Dividend Discount Model *Cash flow forecast – FCFF or FCFE Models *Residual Income – Residual Income Model 5. MAKE THE INVESTMENT DECISION - After valuing the asset is it worth investing in it? Undervalued (MP < IV) Buy the asset, Overvalued (MP > IV) Sell it or don’t buy.