Question

1)    Presented below are specific characteristics of individual firms, industries, markets, or economic conditions. For each, suggest the most likely “best” method of valuating that equity and a short rationale for that choice.

-A growth technology firm that pays no dividends;

-A blue-chip firm that has paid dividends regularly for 40 years, with no major market changes or threats on the immediate horizon;

-A three year old technology firm with generally considered to have substantial potential for immediate growth in the in market share, followed by a five year period of much slower growth as the market matures

-A firm with a 12% difference in intrinsic value vs. its current market price.

-A company with a substantial one-time charge against earnings in the current year based on a one-time pension-fund adjustment.

-An equity index fund (a fund attempting to mirror the performance of the overall equity market).

-The first 12 months of 2017.

2)    While almost all of the methods are listed above rely on some method of calculation, giving them the appearance of being based on quantitative criterial or analysis, some of the assumptions used in selecting both the method or type of valuation may be susceptible to psychological effects. Note two methods of valuation that are susceptible to social interaction effects- and explaining what the effects are and how they can be counteracted.

3)   In 2017 we have a new President. Assess how the emotions of the overall financial community- and the individual investor, might be affected by either their highly positive, or highly negative, expectations of the actions of the President. Be specific how a prudent institutional investor would need to factor in both positive and negative emotions in their valuation of market conditions.

Answer 1

1) Valuation methods and their rationale

a) highly growing technology firm - since the firm doesn't pay any dividend because it may be in the nascent stage, hence dividend discount model and free cash model can't be applied. FCF is most likely to be negative due to huge investment in fixed assets. So relative valuation method may be best for it say based on the price to sales ratio because sales can't be negative. Even Asset approach h may be applied due to huge assets base.

b) Blue chip firm - Since the company has track record of paying dividend over 40 years, hence dividend discount model is best for it. No market changes can be construed as no change in ownership of the company, hence use of free cash flow approach is ruled out ahead of DDM.

C) Three year old firm - 2 stage DDM is most appropriate as firm will witness high growth during 1st 5 years, hence explicit forecast must be made for the same. But as the firm become mayured, then constant growth rate can vmbe achieved.

d) This question need no answer as valuation of the company has already been derived. Rather here we can advise a trading strategy to be short if IV<Price or go long if IV>Price.

e) Any method based on earnings can be used be it DDM or Free cash flow method or Residual Valuation but adjustment must be made for one time charge ie increase profits by an amount equal to pension charge which is one time. It is because valuation is for future and hence we need to value in the basis of profits to be earned in future and hence off items are to be eliminated as they will not be repeated in future.

f) Index Fund - It will be based on the market values of the shares in which it has invested multiplied by their respective weights in those shares. It is because those shares are quoted. Fundamentally intrinsic value of those companies which are present in the index would depend upon their characteristics which are not given in the question.

g) This do not contain appropriate direction as to what needs to be valued.

2) Psychological Effects on Valuation

DDM - It is suitable for those investors which are looking for minority stake and klhence want to enjoy stream of cash flow in form of dividend. Hence they may prefer DDM ahead of other methods. But some other investors may not use it because they have control perspective, hence they may like to use free cash flow approach. This is not a problem hence need no solution, it depends upon priorities of investors

Residual Income - It capitalises economic profit after deducting charge for the providers of finance. But people may not rely upon it as it uses accounting data as input which is subjected to manipulations by the management, hence some people may prefer other methods like DDM which are based on cash flows. It can be made more efficient by having more transparent accounting practices.

Note - Ultimately in real life, psychology also plays an important role. Whatever sound valuation model you may have used, fear of losing and greed of gaining often result in investors taking decisions against what is suggested by the valuation model.

3) Individual investors go by the flow. So if media hypes that a particular action of president is highly conducive to economic growth then retail investors may overvalue all the stocks without carrying out the detailed analysis, while institutional investors would carry out thorough analysis and see what government is doing at ground level to actually implement that decision taken. Only decisions can't create value unless they are implemented well and real assets are created.