How to Value Bonds

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Recent Trend in Stock Valuation By Charnwut
Roongsangmanoon
Ph.D. (Finance) NTU, Singapore expected
2005 M.B.A. (Finance) NIDA, Thailand 1997 B.Eng.
(Chemical Engineering) CU, Thailand 1993
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Outline
INTRODUCTION

• Basic Equity Valuation
• Equity Valuation in a Complex Market
• FactorBased Models
• Applied Equity Valuation
• Conclusions

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1. Basic Equity Valuation
INTRODUCTION
Stock Valuation and Stock Selection - Aim of
equity valuation ? To determine fair price. - Aim
of active equity selection ? To detect
mispricing. This detection provides superior
returns as their prices correct to fair value.
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Basic Asset Valuation
INTRODUCTION
PV present value of asset CFi net cash
flows at period i ri (required) rate of return
at period i
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The Present Value of Common Stock
INTRODUCTION
P0 present value of the stock Divi net
cash flows at period i ri (required) rate
of return on the stock at period i
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The Present Value of Common Stock
INTRODUCTION
Zero Growth Constant Growth Two-Differential
Growth
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Where does r come from?
INTRODUCTION

• r can be divided into two parts
• Dividend yield
• Growth rate (in dividends)
• In practice, a great deal of estimation error
  involves in estimating r.

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Other Relative Valuation Techniques

• Price/Earning Ratio
• The price earnings ratio is the multiple
• - Calculated as current stock price divided by
  annual EPS

Firms whose shares are in fashion sell at high
multiples. Growth stocks for example. Firms
whose shares are out of favor sell at low
multiples. Value stocks for example.
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Other Relative Valuation Techniques

• 2. Price/Cash Flow Ratio
• cash flow net income depreciation cash flow
  from operations or operating cash flow
• 3. Price/Sales
• current stock price divided by annual sales per
  share
• 4. Price/Book (or Market to Book Ratio)
• price divided by book value of equity, which is
  measured as assets liabilities

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Stock Returns

• Dollar Returns
• the sum of the cash received and the change in
  value of the stock, in dollars.

• Percentage Returns
• the sum of the cash received and the change in
  value of the stock divided by the original
  investment.

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Stock Returns

• Dollar Return Dividend Change in Market Value

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2. Equity Valuation in a Complex Market
INTRODUCTION
The equity market is a complex system Random
systems, e.g. Brownian motion, cannot be modeled
and are unpredictable. Ordered systems are
determined by some variables. The complex system
of equity market can be at least partly modeled,
but only with great difficulty.
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Why is the equity market complex?
Arbitrage b/w intrinsic valuation and mispricing
due to segment concentration
Different investment styles
Markets tenuous balance
integrating
integrating
This tenuous balance between integration and
segmentation is one dimension of its complexity.
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What should a smart investor do?
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Stock Valuation in a Complex Market
INTRODUCTION
Situation Different investment styles cause
market segmentation while other forces (e.g.
arbitrage opportunities) act to integrate
it. Need Investors need an approach that
accounts for broad stock behavior, without losing
sight of significant differences in price
behavior of particular segments.

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INTRODUCTION
3. FactorBased Models
Three types Statistical factor
models Macroeconomic factor models Fundamental
factor models
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INTRODUCTION
Statistical factor models
Factor analysis Aim to explain the linear
relation of observed stock returns with factor
realizations. Pro purely statistical
tools Con problem of interpretation Example
principal component analysis
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Systematic Risk and Betas

• The beta coefficient, b, tells us the response of
  the stocks return to a systematic risk.
• In the CAPM, b measured the responsiveness of a
  securitys return to a specific risk factor, the
  return on the market portfolio.

• We shall now consider many types of systematic
  risk.

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Portfolios and Factor Models

• Now let us consider what happens to portfolios of
  stocks when each of the stocks follows a
  one-factor model.
• We will create portfolios from a list of N stocks
  and will capture the systematic risk with a
  1-factor model.
• The ith stock in the list has returns

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Relationship Between the Return on the Common
Factor Excess Return
Excess return
If we assume that there is no unsystematic risk,
then ei 0
The return on the factor F
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Relationship Between the Return on the Common
Factor Excess Return
Excess return
Different securities will have different betas
The return on the factor F
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Portfolios and Diversification

• We know that the portfolio return is the weighted
  average of the returns on the individual assets
  in the portfolio

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Portfolios and Diversification

• The return on any portfolio is determined by
  three sets of parameters

In a large portfolio, the third row of this
equation disappears as the unsystematic risk is
diversified away.
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Portfolios and Diversification

• So the return on a diversified portfolio is
  determined by two sets of parameters
• The weighed average of expected returns.
• The weighted average of the betas times the
  factor F.

In a large portfolio, the only source of
uncertainty is the portfolios sensitivity to the
factor.
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Macroeconomic factor models
INTRODUCTION
Aim to determine macroeconomic variables that
are pervasive in explaining historical stock
returns. Example BIRR model (five variables)
confidence, time horizon, inflation, business
cycle and market timing. RAM model (six
variables) economic growth, business cycle,
long-term and short-term interest rate, inflation
shock, change in US dollar.
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Fundamental factor models
INTRODUCTION
Aim to relate company, industry and market
attributes to cross-section of stock
returns. Example Wilshire Atlas Factor
(seven) E/P, BV/P, market capitalization, net
earning revision reversal, earnings torpedo,
historical beta.
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Goldman Sachs Asset Management Factors
INTRODUCTION
1. BV/P 2. EPS/P 3. EBITD/Enterprise
value 4. Estimate revisions 5. Price
momentum 6. Sustainable growth 7. Beta
8. Residual risk 9. Disappointment risk.
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4. Applied Equity Valuation
INTRODUCTION
Aim - to relate risk factors to average stock
returns. - to do stock selection Procedure -
Research - Implementation - Performance
Attribution  - Process Enhancement
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Procedure
INTRODUCTION
1. Research-Developing the strategy     - Constru
cting the component models - Combining the
models - Statistical evaluation of the models
- Back-testing portfolio simulation 2.
Implementation-Putting it into action
Portfolio construction-Optimization Portfolio
analysis
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Procedure
INTRODUCTION
3. Performance Attribution-Evaluating the
strategy       Portfolio performance       Model
performance 4. Process Enhancement-Closing the
loop
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Size Effect in SET (1)
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Size Effect in SET (2)
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Size Effect in SET (3)
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5. Conclusions

• An approach to stock selection that has both
  breadth of inquiry and depth of focus can enhance
  the number and goodness of investment insights.
• Although the approach requires more time, effort
  and ability, it will be better positioned to
  capture the complexities of security pricing.

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