Introduction to Valuation

Chapter 3
Slides by:
Pamela L. Hall, Western Washington University

Francis & Ibbotson Chapter 3: Introduction to Valuation 1

 Background
 Determining current price of a security is easy
– Ask the seller
– Look in newspaper, television, Internet
 Much more difficult to determine the value of an
investment
– How much is an investment worth?
• Need to know so you can determine if the investment is over-
or under-valued
 Chapter presents the discounted present value model
to estimate value of an investment
– Demonstrates examples of valuing stock, bond and rental
property

Francis & Ibbotson Chapter 3: Introduction to Valuation 2

 Background
 Security price fluctuations may appear chaotic
– Responses to market’s reaction to random arrival of new
information
 When you buy or sell a security you are part of
market
 Hedging is a technique that reduces risk
– One form of hedging is arbitrage
• Aligns prices with respect to law of one price
 Informed buying, selling, hedging and arbitrage
tends to make a security’s price move closer to its
value

Francis & Ibbotson Chapter 3: Introduction to Valuation 3

 Time Value of Money
 One-period rate of return
Terminal Value - Present Value
Rate of Return 
Present Value

 Rearranging this equation gives us the time value

model
1  rate of return Present Value   Terminal Value
 The two models are equivalent because
 The interest rate on the investment equals lender’s one-
period rate of return
 The present value of an investment is
Terminal Value
Present Value 
1 r
Francis & Ibbotson Chapter 3: Introduction to Valuation 4
 Time Value of Money
If the rate of return differs from the discount
rate, we can rewrite the equation as
Terminal Value
Present Value 
1 k
Situations in which the discount rate (k)
differs from the rate of return (r) are common
 Different people have different opinions, different
resources, etc.
If k > E(r) asset is over-priced
 Present value of asset < its price
If k < E(r) asset is under-priced
 Present value of asset > its price
Francis & Ibbotson Chapter 3: Introduction to Valuation 5
 An Exchange
 Francois deposits 100 euros in a French bank
– He receives a negotiable CD with a maturity value of 105
euros
– Expects to earn 5% a year for one year
 An American has a required rate of return of 3%
– Economic conditions are not the same in U.S. as they are in
France
 You and Francois are not concerned with exchange
rate risk
– Believe that exchange rate will remain constant over the
next year

Francis & Ibbotson Chapter 3: Introduction to Valuation 6

 An Exchange
Francois values the CD at
105 euros
 100 euros
1  0.05
 You decide to offer to buy Francois’ CD today
 What price are you willing to pay?
105 euros
 101.94 euros
1  0.03
 Will Francois be willing to sell?
 Yes, because it is worth only 100 to him
• He would get more than he thinks it is worth
 Are both parties pleased with the transaction?
 Yes!

Francis & Ibbotson Chapter 3: Introduction to Valuation 7

 Valuing Coca-Cola at Different Discount Rates

Coca-Cola (ticker symbol: KO) is

currently selling for $54
– You expect the selling price in one year to
be $64 and that KO will pay $0.80 in
dividends during the year
– Based on that information, your expected
rate of return would be
$64 - $54  $0.80  20% or $64  $0.80 - 1  20%
$54 $54

Francis & Ibbotson Chapter 3: Introduction to Valuation 8

 Valuing Coca-Cola at Different Discount Rates

If your required rate of return were 19%, you

would think that KO was underpriced at $54
$64.80 The most you are willing to
 $54.45 pay, which is greater than
1  0.19 the current price of $54.

If your required rate of return were 20%, you

would think that KO was correctly priced at
$54
$64.80
 $54.00
1  0.20

Francis & Ibbotson Chapter 3: Introduction to Valuation 9

 Valuing Coca-Cola at Different Discount Rates

If your required rate of return were

21%, you would think that KO was
over-priced at $54
$64.80 The most you are willing to
 $53.55 pay, which is less than
1  0.21 the current price of $54.

Francis & Ibbotson Chapter 3: Introduction to Valuation 10

 Time Value of Money: Multi-Period Models

 Present value model can value investments that span

multiple time periods
Present Value (PV)  CF  CF    CF
1 k  1 k  1 k 
1 2 k
1 2 k

 Since some cash flows can be expected to last

forever, sometimes the terminal time period is

PV   CF
infinity t

 
t 1 1 k
t

 The value of a cash flow series is the discounted

present value of all future cash flows
 Where the discount rate, k, represents the cash flow’s
appropriate required rate of return

Francis & Ibbotson Chapter 3: Introduction to Valuation 11

 Time Value of Money: Multi-Period Models

Cash flows can be

– Cash dividends
– Coupon interest
– Rent income from real estate
– Asset’s selling price, etc.

Francis & Ibbotson Chapter 3: Introduction to Valuation 12

 Example: PV of a Bond
Bond investors receive periodic
coupon payments and a principal
repayment upon maturity
– For a three-year T-note this can be
represented as
Coupon 1 Coupon 2 Coupon 3  Par
PVbond   
1  YTM  1  YTM  1  YTM 
1 2 3

Francis & Ibbotson Chapter 3: Introduction to Valuation 13

 Example: PV of a Bond
• The discount rate is the rate that equates the
PV of all future cash flows to the bond’s
current market value
– Yield to maturity
• Par value represents the principal, or face
value, of the bond
• Coupon represent the periodic interest
payment
– Coupon % × par value

Francis & Ibbotson Chapter 3: Introduction to Valuation 14

 Example: PV of a Bond
If the bond has a coupon rate of 6%, a
yield to maturity of 5.5%, and a par
value of $1,000 the bond’s present
value is
$60 $60 $60  $1,000
PV   
1.055 1.055 1.055
bond 1 2 3

 $56.872  $53.907  $902.710

 $1,013.489

If the bond can be purchased

for less than this amount it
is a good investment.
Francis & Ibbotson Chapter 3: Introduction to Valuation 15
 Present Value of a Perpetuity
Perpetual investments pay fixed cash flows
forever
– No principal repayment
– Similar to buying a perpetual annuity that can be
sold to another owner
Perpetuities are valued using the following
formula 
PV   CF t

1 k 
t 1
t

 CF  CF  CF  CF   3

1 k  1 k  1 k  1 k 

1 2 4
1 2 3 4

CF

k

Francis & Ibbotson Chapter 3: Introduction to Valuation 16

 Example: Valuing a Consol
A Consol is a bond that pays a constant
coupon to infinity with no repayment
of principal
– You are considering investing in a Consol
with a yield to maturity of 5.9%
• The bond pays an annual coupon of £70
• What price would you be willing to pay for
the bond?
70 Most you are
PV   1,186.44 pounds
0.059 willing to pay.

Francis & Ibbotson Chapter 3: Introduction to Valuation 17

 Example: Estimating Value of Stock
You are considering purchasing stock
– You think you should earn a required rate of
return of 14.5% based on the stock’s risk level
– You expect to sell the stock for $40 in two years
– You expect to receive $2 in cash dividends each
year for the next 2 years
– What is the most you would be willing to pay for
the stock?
$2 $2 $40
PVstock   
1.145 1.145 1.145
1 2 2

 $1.7467  $1.5255  $30.510

 $33.783

Francis & Ibbotson Chapter 3: Introduction to Valuation 18

 Example: Stock With
Constant Perpetual Growth Rate
 You are considering purchasing stock in a large
corporation with the following attributes
– The current price of the stock is $51.50
– You believe the current dividend of $3 will grow at a 3%
rate in the foreseeable future
– You think 13% is a fair discount rate for stock of its risk
level
• What is the most you would be willing to pay for the stock?

PV = Div 1  g 
1
$3 1  0.03

k g 0.13  0.03
$3.09 You should decide to not purchase the stock
  $30.90 because it is priced far above the maximum
0.10
you are willing to pay.

Francis & Ibbotson Chapter 3: Introduction to Valuation 19

 Example: Estimating Value of
Perpetual Preferred Stock
The current market price of a share of
preferred stock is $50
– The stock pays an annual cash dividend rate of
4.5% of its $100 par value
• The annual cash dividend is fixed
– You believe the appropriate required rate of
return on stock of this level of risk is 13%
– What is the most you would be willing to pay for
the stock? You should decide to not
PV 
CF $4.5% x $100
 purchase the stock because it is
k 0.13 priced far above the maximum
$4.50
  $34.615 you are willing to pay.
0.13
Francis & Ibbotson Chapter 3: Introduction to Valuation 20
 Example: Valuing a Real Estate Investment

You are thinking about buying a house and

renting it
– The annual net rental income will be $10,000
– You think you can sell the house for $110,000
three years from now
– What is the most you would be willing to pay for
the house if the discount rate is 10%?
Should not $10,000 $10,000 $10,000  $110,000
pay more than PVrental property   
1.1 1.1 1.1
1 2 3

this amount
 $107,513
for the rental
property.

Francis & Ibbotson Chapter 3: Introduction to Valuation 21

 Making Buy-Sell Decisions
Professional investors use their value
estimates to make buy-sell decisions
If an investor could compute the value of an
investment with certainty, the following
simplified buy-sell rules would apply
– If a security’s price < value it is underpriced and
the investor should buy
– If a security’s price = value it is correctly priced
and the investor should not trade
– If a security’s price > value it is overpriced and
the investor should sell (or sell short)

Francis & Ibbotson Chapter 3: Introduction to Valuation 22

 Making Buy-Sell Decisions
Selling overpriced securities brings
their price down
Buying underpriced securities brings
their price up
Security prices are constantly changing
as new information arrives
In a world of uncertainty it is
impossible to know the value of an
asset with certainty
Francis & Ibbotson Chapter 3: Introduction to Valuation 23
 Making Buy-Sell Decisions
 Some investors enjoy a competitive advantage over
other investors
– Better educated
– Have access to more financial information
– Receive information sooner
 It is rational for investors to behave as though a
security’s price is equal to its value
– Otherwise, you may be betting against anonymous experts
with deep pockets
 Security analysts are paid millions of dollars to
provide value estimates for a few securities
– Will develop a track record (professional reputation)

Francis & Ibbotson Chapter 3: Introduction to Valuation 24

 Long Positions
Simplest investment strategy
– Buy securities you think are underpriced
and hold them in anticipation of a price
increase
• Rate of return
r
P1 - P0   Cash Flows
P0

Francis & Ibbotson Chapter 3: Introduction to Valuation 25

 Short Positions
 A short sale would be used if an investor thought a
security were overpriced (and the investor did not
currently own that security) and would fall in value
– Involves selling a security you do not own
– Borrow the security from a third party
• Most brokerages are happy to lend shares to short sellers
– The short seller will eventually cover his position by
buying the stock
• At a lower price than it was sold (hopefully)
– Short seller sells first and buys later, whereas a long buyer
buys first and sells later

Francis & Ibbotson Chapter 3: Introduction to Valuation 26

 Short Positions
Rate of return
 -  - Cash Flows
r  P0 P1
P0
Example:
 Some time ago, you thought that at its
then-current price of $64 the stock for
ABC Company was overpriced. You sold
the stock short at $64.

Francis & Ibbotson Chapter 3: Introduction to Valuation 27

 Example: Return from Short Position
 Now the stock is selling for $66.50 and you think
that, unfortunately, the stock price will rise even
more.
You decide to cover your short sale.
Also, during the time that you had shorted the stock, the
new owner received $3.90 in dividends. You are required
to reimburse the third party from whom you borrowed the
shares by the amount of the dividends.
 What is your realized return from this transaction?

r
$64 - 66.50 - $3.90  -10%
$64

Francis & Ibbotson Chapter 3: Introduction to Valuation 28

 Complications with Short Positions
If common stock pays a dividend while on
loan to short seller, short seller must
reimburse lender for the amount of cash
dividends
Short seller may be required to put up
‘margin money’
– Represents a good-faith deposit
– May total as much as 100% of the value of the
borrowed shares if you are a small individual
investor

Francis & Ibbotson Chapter 3: Introduction to Valuation 29

 Gain-Loss Illustrations
 Mr. Optimist buys a long  Mr. Pessimist sells short
position Enjoys
unlimited Short sale

Gain
price, $50
Gain

potential for
gains.

$10
$40 $ Market Price $ Market Price
$0 $0
$40

Loss
-$10 Purchase
price, $50
Loss

Losses are
unbounded (if
Slope of line is -1, price rises
Slope of line is +1,
meaning one dollar of infinitely
meaning one dollar of
profit (loss) is made for high).
profit (loss) is made for
each dollar the market
each dollar the market
price falls (rises).
price rises (falls).
Francis & Ibbotson Chapter 3: Introduction to Valuation 30
 Gain-Loss Illustrations
The long buyer also enjoys limited
liability
– Most investor can lose is the amount of
the invested funds (100%)
The short seller can only gain a
maximum of 100%
– If the underlying asset become worthless
and it costs the short seller nothing to
cover his position

Francis & Ibbotson Chapter 3: Introduction to Valuation 31

 A More Realistic Valuation
And Investment Procedure
In reality the valuation process is
complex
– For example, a security’s risk can change
which affects its value
– It is also never-ending

Francis & Ibbotson Chapter 3: Introduction to Valuation 32

 Figure 3-3:
A Flowchart of the Endless Valuation Process

Francis & Ibbotson Chapter 3: Introduction to Valuation 33

 How Price and Value Interact
Consider two hypothetical groups of
investors
– Liquidity traders
• Buy securities when they have excess liquidity
– Perhaps due to income tax refund, inheritance
• Sell securities when they need liquidity
– Buy a house, finance child’s education
• Usually do not buy or sell at times selected to be
advantageous
– Often do not investigate whether a security is over-,
under-, or correctly-priced
• Millions of liquidity traders, but their daily trading does
not usually impact market prices
– Random transactions cancel out
Francis & Ibbotson Chapter 3: Introduction to Valuation 34
 How Price and Value Interact
– Information traders
• Have resources to discover new information
• Form estimates of security values
• Recognize significant deviations of the market price
away from the consensus estimate of a security’s value
• Make informed buy-sell transactions based on whether
they think security is over- or under-valued
• Attempt to maximize their trading profits
• Volume of trading tends to align market price with its
value

Francis & Ibbotson Chapter 3: Introduction to Valuation 35

 Comparing Differences
Between Prices and Values
Consensus value estimate
– Will be narrow if most security analysts
have similar value estimates
• Security’s price will fluctuate in a narrow
range around this value estimate
– Will be wide if there is a great deal of
variability in security analysts’ value
estimates
• Security’s price will fluctuate wildly

Francis & Ibbotson Chapter 3: Introduction to Valuation 36

 Figure 3-4:
Illustration of Three Different Hypothesized Price-Value Relationships

Price never deviates

from value because
numerous (all)
investors are making
rational, informed
buy-sell decisions.

Only a moderate
number of
investors were
making
informed buy-
sell decisions.

Francis & Ibbotson Chapter 3: Introduction to Valuation 37

 Information Content of Prices
 Weakly efficient price
– Reflects all historical information
– Does not reflect current information or insider information
 Semi-strongly efficient price
– Reflects all historical information
– Reflects all current information
– Does not reflect inside information
 Perfectly efficient price
– Reflects all historical information
– Reflects all current information
– Reflects all inside information

Francis & Ibbotson Chapter 3: Introduction to Valuation 38

 Information Content of Prices
If the market is inefficient with respect
to new information
– Securities analysts would earn huge
profits from their buy-sell decisions

Francis & Ibbotson Chapter 3: Introduction to Valuation 39

 Passive Vs. Active Investment Management

Evidence suggests that the U.S.

securities markets are not perfectly
efficient
– Securities analysts can profit from finding
under- and over-valued securities
• Encourages many investors to follow active
management techniques

Francis & Ibbotson Chapter 3: Introduction to Valuation 40

 Active Investment Management
 Example: You estimate the following values for KO
PV of
Estimated Estimate Estimated Estimated
Year EPS d DPR Dividends Dividend
1998 (Actual) $1.42 42% $0.60 $0
1999 (Actual) $0.98 65% $0.64 $0
2000 (Est.) $1.45 47% $0.68 $0.6018
2001 (Est.) $1.64 44% $0.72 $0.5639 Sum =
2002 (Est.) $1.85 41% $0.76 $0.5267 $2.18
2003 (Est.) $2.09 38% $0.80 $0.4906

Francis & Ibbotson Chapter 3: Introduction to Valuation 41

 Active Investment Management

You forecast a P-E ratio of 40 times

2003’s estimated EPS of $2.09
– Your expected price in year 2003 is
• 40 x 2.09 = $83.60 which has a present value
(in 2000) of $51.27
Your estimate of KO’s value in 2000 is
– $2.18 + $51.27 = $53.45

Francis & Ibbotson Chapter 3: Introduction to Valuation 42

 Passive Investment Management
Many studies suggest that the market is
efficient in the semi-strong form
– Suggests that the search for incorrectly-
valued stocks may be too much trouble
• Many passive investors invest in index funds
– Mutual funds designed to track a particular market
index
» S&P500 Composite Index is the most popular

Francis & Ibbotson Chapter 3: Introduction to Valuation 43

 Hedging
 Hedging is usually undertaken to reduce losses from
adverse price movements
 A perfect hedge is a combination of long and short
positions with the objective of eliminating risk
An investor takes a
$44 long (and a short)
position in a stock
Gain

If the price rises to

$26
with a purchase
$70, the investor Long Profits at $70 (sell) price of $44.
will win on his If the company
$0 Market Price
long position but goes bankrupt,
lose the same $70 Short Losses at $70
$44 investor will lose
amount on his short -$26
Loss

(win) $44 on his

position, leaving long (short)
him with a $0 position, leaving
-$44
profit. him with a $0 loss.

Francis & Ibbotson Chapter 3: Introduction to Valuation 44

 Imperfect Hedges
A hedge is imperfect if a profit or loss results
– Example: KO’s stock is selling for $40 in
London and $41 on the NYSE.
• Arbitrageurs would buy the stock on the London
exchange (because it is cheaper than the NYSE) and
short sell the stock on the NYSE.
– This would bid up the price on the London exchange and
drive down the price on the NYSE
» This would continue until the prices on both the
London exchange and the NYSE were equal

Francis & Ibbotson Chapter 3: Introduction to Valuation 45

 Arbitrage
Arbitrage involves buying a long position
and selling a short position
– In the same asset or different (but related) assets
• To capitalize on unrealistic price differences
Enforces the economic law of one price
– Price of the same asset is the same in all free
markets
• Prices may actually differ due to transaction costs
– Brokers commissions
– Foreign exchange fees
– Governmental foreign exchange controls
– Telephone costs

Francis & Ibbotson Chapter 3: Introduction to Valuation 46

 Arbitrage
Who benefits from arbitrage?
– Everyone
• Arbitrage makes security prices respond
rationally, efficiently and uniformly to new
information
– Keeps the price of a good that is scarce in one
location but plentiful in another reasonable
– Helps allocate resources geographically and
through time

Francis & Ibbotson Chapter 3: Introduction to Valuation 47

 The Bottom Line
Value estimates form the basis for wealth-
maximizing investment decisions
Security prices fluctuate due to changing
value estimates by investors
Some investors follow an active investment
strategy while others follow a passive one
Market prices adjust to rapidly reflect new
information
Actions taken by profit-seeking speculators,
short sellers, hedgers and arbitrageurs help
allocate scarce resources
Francis & Ibbotson Chapter 3: Introduction to Valuation 48