Question

a. Why might investors opt to hold shares rather than bonds in their potfolios (you may want to define what portfolios are first)
b. In valuing shares, several valuation methods have been highlighted. What are they and which one is superior (simpler) among them?
c. Explain the valuation errors in relation to valuing equity shares

Answer 1

A. Portfolio is combination of various securities which are owned by investors in order to make a higher rate of return and this portfolio will be having up allocation of capital into different securities with different risk and different return.

investor will opt to hold share rather than Bond in their portfolio because share will be having a higher potential of returning higher, and they will also be having a capability of returning back dividend and they can appreciate quickly than the bond and they are not risk free in nature.

Bonds are generally considered an investment for Risk averse investor and they are always used for diversification rather than primary allocation in the portfolio whereas stock are primary allocation in the portfolio for majority of the investors who are not old and they have a potential of higher return.

B.various valuation models are discounted cash flows models, along with dividend discounting models, and multiples valuations method which valued valuation model like price to earning and price to book and Enterprise evaluation.

Discounted cash flow method is the simplest and the best method which will be discounting the cash flows which is accruing to the company and this will be discounting this cash flows at the present and dividing the total number of share in order to arrive at the intrinsic value of the share and find the discrepancy in the price and the intrinsic valuation in order to capitalise upon that in order to make a higher rate of return

C. Valuation errors in respect of valuation of equity shares would be of following types and this valuation errors can be attributed to wrong projection of the growth rate of the company and wrong projection of the cash flows of the company in the future so the entire valuation of the equity share will be wrong

when we are using discounted cash flows method for valuation or other valuation model and we are not able to judge with the cash flows and the growth rate properly, then we are going to find the wrong intrinsicvalue and it is going to hurt the overall potential of share valuation and it will lead to wrong valuation and it will also linked to wrong reinvestment losing a lot of capital.

So proper valuation models are to be adopted along with the proper projection of cash flows and growth rate in order to arrive at correct intrinsic value in order to invest into the market.