Question

Tony Lee, a CFA, is an analyst specialising in bond valuation; while Ann Jones, also a CFA, is an equity analyst specialising in stock valuation. Who faces greater difficulty in the security valuation? Explain why.

Answer 1

Ann Jones, specialized in equity or stock valuation faces greater difficulty compared to Tony Lee who is specialized in stock valuation. There are reasons attached to it.

Reasons

1) Investing in equity has higher risk than investing in bond market as equity share holders receive the payment at the last in event of liquidation. Bond holders always have prefernece to equity holders in payment. In event of liquidation bond holders have first claim on the assets compared to shareholders. So there is more risk in equity investments. That risk has to be incorporated in valuation. It is not so easy to calculate that risk.That risk is demonstrated by Capital Assets Pricing Model (CAPM). But the CAPM model requires many assumptions like beta calculation, time frame (keeping in mind the business model of the company is uncanged), benchmark selection (where an analyst might get biased and selects an inappropriate benchamrk for comparison) etc.

2) There is a fixed interest component in bond valuation. The same appears on the Income statement of the companies. Interest component can be calculated on basis of terms mentioned in the term sheet while issuing a bond.But in case of equity there is no fixed component like Interest expense. A company might declare dividends or share repurchase program for the investors. A company might not declare a dividend in volatile environment. So dividend is discretionary in common share valuation unlike the interest component.

3) If a company does not declare dividend the analyst has to estimate it for the valuation purpose. In case of bond valuation as one of the component is fixed one can estimate the proper yield to discount those future coupon payment in case of bond valuation. To estimate the yield one has to the matrix pricing valuation.

4) For FCFF (Free cash flow to valuation) and FCFE(free cash flow to equity) almost all of the compnent is same except the fact in FCFE the analyst has to think what futue debt borrowings and debt repayments would be done by the company. This number is not available readily. It has to be estimated depending the macro and micro economic conditions.