Fair Value Of Security

What is Fair Value Fair value is an estimate of a securities true intrinsic worth. While there is no one way to calculate the fair value for a security, one common way takes into account growth rates and discounts them to the present at a rate sufficient to compensate investors for the risk taken. Factor which afftect the prices…… • Market Wide Information – Interest Rates – Risk Premiums – Economic Growth • Industry Wide Information – Changes in laws and regulations – Changes in technology • Firm Specific Information – New Earnings Reports – Changes in the Fundamentals (Risk and Return characteristics)

Securities valuations method Discounted Cash Flow: This is a method which takes into account the future growth prospects of the company’s performance by taking into account past performance of the same for forecasting future cash flows. these forecasted cash flows are then discounted by a appropriate discount rate. These discount rates varies company to company. Disadvantages: Since it is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches • DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. For e.g.: Many internet companies are arguing that selling and G&A expenses are the equivalent of R&D expenses for a high-technology firms and should be treated as capital expenditures. If we adopt this rationale, we should be computing earnings before these expenses, which will make many of these firms profitable. It will also mean that they are reinvesting far more than we think they are. It will, however, make not their cash flows less negative. •

These inputs and information are not only noisy (and difficult to estimate), but can be manipulated by the savvy analyst to provide the conclusion he or she wants. • In an intrinsic valuation model, there is no guarantee that anything will emerge as under or over valued. Thus, it is possible in a DCF valuation model, to find every stock in a market to be over valued. • This can be a problem for: ✔ equity research analysts, whose job it is to follow sectors and make recommendations on the most under and over valued stocks in that sector

✔ equity portfolio managers, who have to be fully (or close to fully) invested in equities

Relative valuation Method The value of any asset can be estimated by looking at how the market prices “similar” or ‘comparable” assets. Disadvantage • • •

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A portfolio that is composed of stocks which are undervalued on a relative basis may still be overvalued, even if the analysts’ judgments are right. It is just less overvalued than other securities in the market.  Relative valuation is built on the assumption that markets are correct in the aggregate, but make mistakes on individual securities. To the degree that markets can be over or under valued in the aggregate, relative valuation will fail  Relative valuation may require less information in the way in which most analysts and portfolio managers use it. However, this is because implicit assumptions are made about other variables (that would have been required in a discounted cash flow valuation). To the extent that these implicit assumptions are wrong the relative valuation will also be wrong. stocks are priced based upon expected margins rather than current margins. For firms where current margins have little or no correlation with expected margins, regressions of price to sales ratios against current margins (or price to book against current return on equity) will not provide much explanatory power.

Contigent Claim (option) Pricing Model Listed options, which are options on traded assets that are issued by, listed on and traded on an option exchange. Warrants, which are call options on traded stocks, that are issued by the company. The proceeds from the warrant issue go to the company, and the warrants are often traded on the market. Disadvantage •

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When real options are valued, many of the inputs for the option pricing model are difficult to obtain. For instance, projects do not trade and thus getting a current value for a project or a variance may be a daunting task. you first need to value the assets. Finally, there is the danger of double counting assets. Thus, an analyst who uses a higher growth rate in discounted cash flow valuation for a pharmaceutical firm would be double counting the patents if he values the patents as options and adds them on to his discounted cash flow value.

Valuation is most difficult when a company:

• Has negative earnings and low revenues in its current financial statements • No history • No comparables (or even if they exist, they are all at the same stage of the life cycle as the firm being valued

Misconception about valuations Myth 1: A valuation is an objective search for “true” value • Truth 1.1: All valuations are biased. The only questions are how much and in which direction. • Truth 1.2: The direction and magnitude of the bias in your valuation is directly proportional to who pays you and how much you are paid.  Myth 2.: A good valuation provides a precise estimate of value • Truth 2.1: There are no precise valuations • Truth 2.2: The payoff to valuation is greatest when valuation is least precise.  Myth 3: . The more quantitative a model, the better the valuation • Truth 3.1: One’s understanding of a valuation model is inversely proportional to the number of inputs required for the model. • Truth 3.2: Simpler valuation models do much better than complex ones.

1) Insider trading Insider trading refers to the trading in the shares by the persons who are in the management of the company or are close to the company or have full information regarding the company (which are generally not available to the outsiders) like: ➢ ➢ ➢ ➢ ➢

Working of the company Announcement of bonus Rights Dividends Important decisions taken by governing board

Some persons connected with the company having confidential information about the company trade in share of their own company can influence the market price

1) Kerb trading Any trading activity, which is conducted outside official trading hours or on non-working days or outside the offer of the brokers, is called Kerb trading. Kerb trading is a sort of parallel market to the official stock market. A major part of these transactions is not reported to the stock exchange. The big operators and manipulators use Kerb market. The prices of the active shares can be easily manipulated in this market with a small volume of business. The insiders can also use the Kerb market in a very effective manner to manipulate the prices.

1) Rigging the market The rigging of the market means artificially forcing up the market price of a particular security. It is the result of a strong bull movement or pushing down the price by the bear operators. Other practices done by the market manipulators to effect the fair value of securities :

Cornering Wash sale transactions inadequate floating stock 1) Over trading

References: http://www.stock-market-investors.com/pick-a-stock-guides/return-on-equity-calculationand-drawbacks.html http://my.safaribooksonline.com/9780470078167/advantages_and_drawbacks_of_structura l_m http://www.quickmba.com/finance/debt-valuation/ http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/inv2E/relval.pdf

http://books.google.com/books? id=wF8yVzLI6EYC&pg=PA80&lpg=PA80&dq=bond+valuation+ %2B+disadvantages&source=bl&ots=zRygyVIi3R&sig=dYzjTOy03Uq8JrRcqc6w44pd00&hl=en&ei=SyOYSsTQBYfe7AORh7m9BA&sa=X&oi=book_ result&ct=result&resnum=1#v=onepage&q=bond%20valuation%20%2B %20disadvantages&f=false C:\Documents and Settings\Students\Desktop\fair value\Fair value111.mht

Extra Investopedia explains Discounted Cash Flow - DCF There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you'd receive from an investment and to adjust for the time value of money. Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on. S & P 500: 2-Stage DDM Valuation Cost of Equity = 4.22% + 1(4%) = 8.22% Terminal Value = 29.18*1.0422/(.0822 -.0422) = 760.28 12345 Expected Dividends = $21.06 $22.85 $24.79 $26.89 $29.18

Expected Terminal Value = $760.28 Present Value = $19.46 $19.51 $19.56 $19.61 $531.86 Intrinsic Value of Index = $609.98 index is at 1212, while the model valuation comes in at 610. This indicates that one or more of the following has to be true. • The dividend discount model understates the value because dividends are less than FCFE. • The expected growth in earnings over the next 5 years will be much higher than 8%. • The risk premium used in the valuation (4%) is too high • The market is overvalued. Various methods like pbv ps drwbcks One of the limitations of the analysis we did in these last few pages is the focus on current margins. Stocks are priced based upon expected margins rather than current margins. n For most firms, current margins and predicted margins are highly correlated, making the analysis still relevant. n For firms where current margins have little or no correlation with expected margins, regressions of price to sales ratios against current margins (or price to book against current return on equity) will not provide much explanatory power. n In these cases, it makes more sense to run the regression using either predicted margins or some proxy for predicted margins.