Question

 1. Define valuation

 2. Contrast absolute (DCF) and relative valuation models.

 3. Discuss the CAPM approach to determining the required rate of return for an equity investment

 4. What are the sources of bias in valuation?

Answer 1

1. Valuation is a method of computing the market value of a company and it's assets. There are mnay techniques used for valuation .Absolute valuation techniques, which looks at firm's future earnings. the realtive valuation models, looks at the current price and earnings and cash flows.

2. the absolute valuation techniquies only looks at the value of the asset derived from the characteristics of an asset. It has nothing to do with the comparables that are trading in the industry. These models are generally called the discounted cash flow models.

relative valuation models do not value a firm or an asset based on it's intrinsic value. In fact it compares the value of an asset based on a benchmark value. When we value all the stocks in the child care industry we get a PE ratio of 25, and when we compare the PE ratio of johnsons and johnsons with this measure we find that J&J is valued at 17 times it's earnings whereas the market is valaued at 25 times its earnings .We couls use p/sales , price/value, price/ cash flow also as relative valuation models.

3. The CAPM approach to determine the required rate of return is :

Re = Rf + b( Rm - RF)

WHERE,

Re = required return on equity

Rf = risk free rate

Rm = return on the market.

4.The bias in valuation starts with the asset taht we choose to value. Thses choices are random, and we are laying the foundation for bias. When we choose the information concerning the asset we choose the information that satisfies the person who has handed over the assignment to us.

analysts more often provide buying recommendations than selling ,so they are most probably going to reach at conclusions that the assets are undervalued rather than overvalued.An analysts compensation when dependent on finding undervalued assets will be more biased towards that.

while making valuations ,we have to make assumptions . These asumptions in most cases are biased and they overestimate a firm's earnings.