Summary INV3701 NOTES 2021

INV3701 - Equity asset valuation Chapter 1: Applications and processes A. Value definitions i) Introduction The key question faced by those in the investment field: WHAT IS THE VALUEOF A PARTICULAR ASSET? The answer to this question will normally determine the success or failure of an investment decision. We can define VALUATION as the estimation of the value of an asset: - based on variables that relate to future investment returns - by comparing it to similarassets - based on estimates of its liquidation proceeds (if appropriate) ii) Definitions We will now look at different concepts of value: 1. Fair market value and investment value Fair market value is the price that a willingbuyer and a willingseller are prepared to exchange assets or liabilities at when neither the buyer nor the seller are under any compulsion to buy or to sell. Another assumption relating to fair market value is that both the buyer and the seller have information regarding the material aspects of the asset or liability. Fair market value is also knownas the market price of the stock. Example: The market value of a stock would be the latest price that the stock traded at on the stock market. For example Apple Inc’s closing rd of priceNovember on the 23 2015 was $119.40. This is the market price for Apple Inc. It is important to note that this market value of $119.40 is the equity value of an Apple share. This excludes the value of Apple Inc’s debt and preference shares. © Edge | INV3701 | Presented by: Russell Jude | Date: 2017 3 Investment value is value that is attributable to a specific buyer based on this buyer’s specific set of circumstances and requirements, e.g. specific synergistic benefits to be achieved by purchasing the asset. 2. Intrinsic value The intrinsic value of an asset is the value of the asset assuming that we have a complete understanding of all the asset’s investment characteristics. This in practice is not correct since if it were then the intrinsic value of an asset and the market value of an asset would be the same – which it seldom is. 3. Estimated value Estimated value is the value that the investment manager estimates to be the correct intrinsic value. He will do this by analyzing data as well as detailed valuation models as well as forecasts and other techniques. This estimated value will seldom equal the real intrinsic value of the asset due to the nature of the valuation process. The estimated value is the value that the analyst will arrive at after doing extensive research work and then performing his valuation. The more work done the greater and the closer the estimated value will be to the intrinsic value. 4. Going-concern A going-concern assumption assumes that the company will continue operating in the foreseeable future. EDGE NOTE: It is interesting to note that the assumption of the efficient market theory is that the market value and the intrinsic value of an asset shouldquite closely approximate each other. This theory has been disputed by modern theorists who often seek to identify mispricing between the market value and the intrinsic value of an asset. However, they do agree that over time the market value will converge towards the intrinsic value. © Edge | INV3701 | Presented by: Russell Jude | Date: 2017 4 5. Liquidation value A company that is in financial distress and that may not be able to operate in the foreseeable future will be valued based on its liquidation value. This value is the value if the company were to be dissolved and its assets sold off. 6. Orderly liquidation value Another method of liquidation will be when the assets are sold in an orderly manner and not on a fire-sale basis. In this case the values achieved for the assets will typically be higher than in a normal liquidation sale. This type of liquidation is referred to as an orderly liquidation valuation. In most cases the value on a going-concern basis will be higher than the value based on a liquidation basis. iii) Assetmispricing Based on the above we do say that mispricing between the intrinsic value and the market value of an asset can and does occur! Therefore the job of an active investment manager is to seek out these mispricings and take advantage of them. Mispricing can therefore be defined as the difference between: - The intrinsic value of the asset as estimated by the investment manager – also knownas the estimated value, AND - The market value of the asset Example: Assume that an investor earns a positive return from convergence of price to intrinsic value. I.e. A positive return is earnedwhen the market price converges (moves towards) the intrinsic value (the real value of the stock). When would this situation likely occur? Solution: This would occur when the expected return is greater than the required return. Abnormal return