Equity valuation & Analysis-Bhargav Buddhadev-06

8/7/2019 Equity valuation & Analysis-Bhargav Buddhadev-06

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Equity Valuation and Analysis

Equity valuation & Analysis

By Bhargav BuddhadevMMS Finance

Roll Number 9

Serial Number Particulars Page number1 Introduction 1

2 Active Investment styles 2

3 Sub categories of active equity

management styles3

4 Equity valuation models 6

5 Valuation models for cyclical stocks 13

6 Models based on price ratio analysis

Price equity ratio 18

Price cash flow ratio 25

Price sales ratio 26

Price book ratio 26

7 Valuation equations

Random valuation model 27

Intrinsic value 28

Market anomaly returns 37

Capital asset pricing model 38

8 Strategies 40

9 Bibliography 43

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Introduction

The security analyst when faced with the problem of a buy or sell decision must first

evaluate the past performance of the security, and then coupled with his personal

experience predict the future performance of the security and the relative market position.

The amount of data available to him far exceeds his potential and therefore he has to base

his predictions on several basic attributes and modify the results in the light of intuitive

beliefs. While the process may be successful, its intuitive segments make the evaluation

of errors and improvements of this technique very difficult, if not impossible.

Equity valuation is difficult in comparison to valuation of bonds and preference shares.

This is because benefits are generally constant and reasonably certain. Equity on the other

hand involves uncertainty. It is the size of the return and the degree of fluctuations, which

in togetherness determine the values of the share of the investor. Therefore forecasting

abilities of the analyst are more crucial in the equity analysis. Infact equity analysis is

based on the notion that the stock market is not working efficiently. In other words active

management is based on the notion that historical and current information is not fully and

correctly reflected in the current price of the stock. Hence there exist stocks that are over

valued and those that are under valued. The task of the equity manager is to decide which

stocks are which and then invest accordingly. By contrast the equity manager who

believes that the market is efficient tends to flow a passive strategy. With indexing being

the most common form of equity strategy.

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Active Equity Investment Styles:

The primary style of active equity management style is top down and bottom up.

The manager who uses top down style begins with an overall economic environment and

a forecast of its nearest outlook and makes a general asset allocation decision regarding

the relative attractiveness of the various sectors of the financial markets (e.g. equity,

bonds, real estate, bullion etc). The manager then analyses the stock market in an attempt

to identify economic sectors and the industries that stand to gain or lose fro the managers

economic forecast. After identifying attractive and unattractive sectors and industries, the

top down manager finally selects the portfolio of individual stocks.

The process is represented in the figure given below;

Economic forecast

Asset allocation

Sector analysis

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Financial markets

Stock markets Other asset markets

Equity portfolio


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A manager who uses bottom up equity approach de-emphasizes the significance of

economic and market styles and focuses instead on the analysis of individual securities.

Using financial analysis and computer screening techniques, the bottoms up manager

seek out stocks that have certain characteristics that are deemed attractive (e.g. low price

earning ratio, small capitalization, low analyst coverage etc)

Sub categories of active equity managementSome of the major sub categories of the two major style of active equity management are

listed below;

Growth managers: Growth managers can be classified as either top-down or

bottom up. The growth managers are either divided into large capitalization or

small capitalization. The growth managers buy securities that are typically selling

at relatively high P/E ratios, due to high earnings growth rate, with the

expectation of continued high earnings growth. The portfolios are characterized

by high P/E ratios, high returns, and relatively low dividend yields.

Market timers: The market timer is typically a set category of top- down

investment style and comes in many varieties. The basic assumption is that he can

forecast the market i.e. when it will go up or down. In the sense he market timer is

not too distant than the technical analyst. The portfolio is not fully invested in

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equities. Rather he/she moves in and out of the market depending on the

economic, technical and analytical skills he/she dictates.

Hedgers: The hedger seems to buy equities but also to place well-defined limits

on the investors investment limits. One popular hedging technique involves

simultaneously purchasing a stock and put option on that stock. The put option

sets a floor on the amount of loss that one can make (if the stock process go

down) while the potential profit (if the stock prices go up) is diminished only by

the original cost of the put. This is an example of the relatively simple hedge.

Value managers: These are sometimes referred to as contrarians. This is because

they sometimes see value where many other market participants dont. These buy

securities that are available at a discount to the face value and sell them at or in

excess of that value. They can fall into either the top down or bottoms up

approach. Value managers use dividend discount.

Group rotation managers: The group rotation manager is in the sub category of

the top down management style. The basic idea behind this technique is that the

economy goes through reasonably well-defined phases of the business cycle,

namely, recession, recovery, expansion and credit crunch. The group rotator

believes that he can discern the current phase of the economy and forecast as to

which phase is going to evolve. He can then select those sectors and economies

that are going benefit. For example if the economy were perceived to be on the

verge of moving from recession to recovery, the group rotator would begin to

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purchase stocks in the appropriate sectors and specific industries that are sensitive

to the pick up in the economy.

Technicians: They discern market cycles and pick up securities solely on the

basis of historical price movements as they related to the projected price

movements. By reading a chart and artfully discerning patterns, the technician

hopes to be able to predict the future path of the price action models P/E, earning

surplus etc. In terms of characteristics, value managers have relatively low betas,

low price book and P/E ratios and high dividend yields.

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Equity valuation modelsThe purpose of these models is to identify whether the stock is overpriced or under

priced. Under priced stocks need to be purchased and over priced stock need to be

shorted?

Present value estimation: It is simply the inverse of future value. If we know

the cash flows that we are going to get in the future course and the interest ratethen we can discount the same and get the present value.

Formula = Future value

(1+I)^n

Let us consider an example. Suppose we have an opportunity to receive 100 a

year from now. Now if the interest rate is 12% then the present value shall be

100

(1+.12)^1

= 89.28

In order to develop a consistent system of security valuation theorem, it has

become fashionable to apply the techniques of present value theory to the

equity valuation.

Let us assume there is an investor whose cost of capital is k and decides to

invest in a company. As a first step he calculates the adjusted earnings per

share over the past few years and examines the stability of earnings and their

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growth and on the basis of these findings and of a companys outlook derives

an estimate of the future earnings of the company. For convenience let us

assume that the future earnings is E, that these earnings will continue

indefinitely into the future. What is the value of such a share to this particular

investor?

Given the data the value can be calculated as below;

V = E + E +. E(1+k) (1+k)^2 (1+k)^t

Thus in this manner the expected stream of earnings, capitalized at the

investors cost of capital measures the intrinsic value of the share. Now we

compare this valuation with the current stock price (P). Now if V-P>0 then the

stock is under priced therefore the investor should purchase it and if it is


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b) Even if both investors have the same cost of capital, differences in their

estimates of the firms profitability may result in different investment

decisions.

Basic model: One of the most used equity valuation model is the dividend

discount model. In its simplest form, the DDM defines the intrinsic value of a

share as the present value of future dividend. These are several variations of

the DDM because of different assumptions about the growth rate of dividend

and its relationship to the discount rate used to calculate present values.

Zero growth models: The most basic of all the DDS is the zero growth

model. This model assumes that the dividend will be constant over time, so

that growth is zero, and that the investors required rate of return is constant.

Constant growth model: In this model cash dividends are expected to grow

at the constant rate. In order to find the discounted present value of the stream

of constantly rising dividends, the investors can use the equation of constant

growth of dividends.

Value = D1

Ke-g

This equation tells us that the value of an equity share is equal to the cash

dividend in time period 1 discounted by the difference between the required

rates of return required by equity investors and growth rate of dividends. In

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using this equation the value of dividend anticipated in the coming year is to

be taken.

For example if an investor has a share whose current cash dividend at time 0

is 4, the constant growth rate of dividend is15% per year and the required rate

of return is 20%, the value of this share will be

Value = 4(1+.15)

.20-.15

= 92

Note that the current price of Rs. 92 is much higher than the Rs.20 where no

growth in future cash dividends was assumed. This is expected since, other

things remaining equal, an investor would value a growing cash flow stream

at a higher rate than a non-growing stream.

Variable growth rate of dividend: Consider a firm grows at a faster rate for a

few years and then reverts to a constant growth rate or no growth situation. This

might occur if the firm has made previous investments that produced high cash

flows, but increasing competition is expected to reduce the future growth rate. In

this case the value of a firm whose growth rate of dividends varies over time can

be determined by the following equation;

Value = Do (1+gx)^t

(1+k)^t

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Where gx = growth rate of dividend for n years.

This equation can be expended any number of times, the ability to change growth

rates allows one to value a share over the life cycle of the firm on the rates of

growth change. If the growth rate of dividends is expected to grow at one rate for

a period of time and then a constant growth rate of dividend, the equation model

is;

Value = Do(1+gx)^t + Dn+1 [ 1 ](1+k)^t (k-gy) (1+k)^n

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To illustrate the use of this multiple growth rate dividend valuation method,

consider the case of this hypothetical company XYZ.

The company paid its first cash dividend of Rs.2.5 today and dividends are

expected to grow at the rate of 30% for the next 3 years. Thereafter cash

dividends are expected to grow at the rate of 10%. Further the shareholders are

expecting 15% rate of return.

Solution:

First we shall calculate the present value of dividends for the first 3 years;

Year Dividend

Do(1+gx)^t

Capitalization rate Present value

(1) (2) (3) (4)=(2)*(3)

0 2.5

1 3.25 .870 2.82752 4.225 .756 3.1941

3 5.493 .658 3.6140

SUM = 9.6356

Step 2

Value at the end of the 3rd year for the remaining life of the company will be;

D3 (1+gx) = 5.493(1+.10)=6.0423

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Therefore value at the end of the third year

V3 = 6.0423

(.15-.10)

= 120.846

Therefore the present value is 120.486* .658 =79.2797

Thus the value of the share is 9.6356 +79.2797 = 88.9153

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Valuation models for cyclical stocks:

Bauman used as well as Clendenin, the present value concept of arriving at the stock

value by discounting at an appropriate yield rate all the future cash flows. He

spells the factors that determine the future dividend income, namely the growth

rate and the growth duration, and argues that a company with a growth rate in

excess of the average shown in an industry will sooner or later finds its growth

rate declining to the average shown in an industry. How long this transition

period lasts depends on the company, industry, product, competition etc A

guide to follow is to determine the probable position of the company in its life

cycle.

For example, if a company has been experiencing an abnormally high growth rate,

Bauman suggests that, unless there is a sufficient evidence to the contrary, the best

earnings and dividend projection is probably based on a decreasing rate of growth, until it

eventually approximates the secular growth rate for the majority of the companies in the

company. For reasons of convenience he makes an assumption in his model that the

growth rate will decline by equal amounts over the span of the transitional period.

According to him in order to make a good estimate of future dividends, the investor must

ascertain

(a) the current growth rate of dividend

(b) how long will it take until the growth rate has declined to the average typical for the

majority of corporations.

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Once the investor has determined the pattern of future dividend incomes he must discount

them to arrive at the present value. What shall be the discount rate? Bauman offers

guidelines from 6 to 10 percent depending on the risk involved.

The discount rate applied to the first years dividend is the lowest, and it

increases with time as the distant years become more and more uncertain.

That is the risk premium added to the discount rate increases with time.

Although he does not tell the investor how much higher future discount rate

must be taken, but he gives a very strong clue by showing what rates were

representative of majority stock exchanges. Bauman relies a lot on historical

data and believes this action is justified by absence at present of any

indicators, which point to large changes ahead. He reminds investors to be

on guard constantly to recognize signs of changes.

Obviously the cyclical model is difficult to formulate even on simple configuration, but it

does point out the variables that must be considered.

Let us assume that a stock has 4 years business cycle from trough to peak to trough, that

the stock pays a regular dividend, and that the investor is willing to trade in and out of the

stock but since the risks are great he must earn a 20% rate of return rather than a 10%

Now if D1 is 1 and D2 is 1.8 and P2 is 80, the present value of the stream of income at

20% is

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Value = 1 + 1.8

(1+1.2) (1+1.2)^2

= 57.08

Therefore, if the stock is available at lower than 57.08 then it would provide the

speculative investor with a yield of over 20%. But what valuation model should we

follow if the speculative investor wished to continue trading in shares, did not wish to sell

short, and therefore was temporarily out of the market. May be his funds were placed in

the savings bank.

V = D1 +D2+CG2 +I3 +D4 +D5 + D6+P6

(1+k) (1+k)^2 (1+k)^3 (1+k)^4 (1+k)^5 (1+k)^6

Where CG2 is the capital gain in year 2, I3 and I4 are interest income and D1 , D2 are

dividends. The equation covers a successful trade from the purchase of stock at the

cyclical low, then to sale at the high and a move to a say 8% savings account then to

repurchase at a low, and a final sale at a peak in year 6. It is obvious that this is difficult

to do in practice and that the cycle might be substantially shorter than six years.

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Model based on price ratio analysis

1. Price earning ratio

The most popular ratio used to assess the value of the equity is the companys price

equity ratio abbreviated as P/E ratio. It is calculated as the ratio of the firms current

stock price divided by the earnings per share (EPS).

The inverse of the p/e ratio is referred to as the earnings yield. Clearly the price earning

and the earnings yield are required to measure the same thing. In practice earnings yield

less commonly stated and used than P/E ratios.

Since most companies report earnings each quarter annual earnings per share can be

calculated as the most recently quarterly earnings per share times four or as the sum of

the last four quarterly earnings per share figures. Most analysts prefer the first method of

multiplying the latest quarterly earnings per share value time four. However the

difference is usually small, but it can sometimes be source of confusion.

Analysts often refer to high P/E stocks as growth stocks. To see why notice that a P/E

ratio is measured as a current stock price over current earnings per share. Now consider

two companies with the same current earnings per share , where one company is a high

growth company and the other is a low growth company. Which company should have a

higher stock price, the high growth company or the low growth company?

The question is a no brainer. These entire equal, we would be surprised if the high

growth company did not have a higher stock price and therefore a higher P/E ratio. In

general companies with higher expected earnings will have higher P/E ratio, which is

why P/E stocks are referred to as the growth stocks.

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The reason why they are referred to high growth stock is simple. The reason is that low

P/E value stocks are often viewed as cheap relative to current earnings. This suggests

that these stocks may represent good investment values, and hence the term values

stocks. However it should be rated that the term growth stock and value stock are most

justly commonly used labels. Of course only time will tell whether a low P/E stock is of

good value.

The P/E ratio used in the valuation equation is influenced by

i) P/E ratios for a group of companies tend to change little from one period to the

next. Therefore an investor cannot expect a dramatic change in the future P/E

ratios. The future level of the P/E ratio can be viewed as the function of the

current P/E ratios or the average P/E ratio over the same period of time.

ii) The P/E ratio is a function of future expected earnings the higher the growth rate

of earnings the higher will be the P/E ratio. An investor will be willing to pay a

higher price forth-current earnings if the earnings are expected to grow at a much

higher rate.

iii) A normal P/E for the market is difficult to determine. A normal P/E ratio

is established for each company but it can be compared to the market P/E to give

some idea of risk. The higher the P/E ratio the higher is the risk. This is true

inspite of the fact that the investors are ready to pay more.

iv) Inflationary conditions tend to reduce the P/E ratios.

v) P/E ratios vary by the industry

vi) Higher interest rates tend to reduce the P/E ratios

vii) P/E ratios vary by the industry

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viii) An investor should examine the trend of the P/E ratio over time for each

company.

ix) The level of P/E ratio is not an absolute one but a relative one.

x) Speculative companies and cyclical companies tend to have a lower P/E

xi) Growth companies tend to have a higher P/E

xii) Companies with larger portion of debt tend to have a lower P/E

xiii) A company that tends to pay a higher dividend tend to have a higher P/E

xiv) P/E ratios can change radically and suddenly because of change in the expected

growth rate of earnings. Therefore the greater the expected stability of the growth

rates the higher the P/E ratio.

How can the P/E ratio be used as guide in making an investment decision? For this the

analyst is to apply various rules of thumb on companys earnings selecting an

appropriate P/E ratio to determine the value of its shares. The resulting price is to be

compared with current market price to assess the relative magnitude of the ratio. Taken

from the historical record of the equity in question the determination of the current

equity must be followed by a standard of comparison. For this the analyst mat ascertain

the median or the mean P/E for the equity as well as its range over the time. More weight

can be given to the recent past. This provides boundaries within which the P/E must fall

and indicates whether the equity is tending to sell at the upper limits of expectation or

the lower limits. Industry P/E provide the guidelines, however the different companies in

the same industry frequently carry different P/Es.

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Robert Ferguson presents a method of determining justifiable price earnings ratio for

growth stocks as compared to the standard. His objectives are to answer the following

questions:

A) How many years of the present high growth rate are assumed by todays market price

before the growth rate of the company drops to the standard rate?

B) What price earning ratio is justified given a certain growth rate which is higher than

the standard rate for a certain number of years ?

Ferguson takes the market price as a base and then determines what estimates of the

basic factors the market makes. He then leaves the investors to decide whether these

estimates are too low or too high in his judgement. Ferguson develops a nomograph

which eliminates the need for complicated calculation on the part of the investor. The

nomograph is a graphical solution to the equation.

Pa = (1+Ra)^n

P1a (1+Rb)^n

Where

Pa = some standard price earning ratio

P1a = growth stock price earning ratio

Ra = standard growth rate assumed

Rb = rate of growth assumed for growth stock

Although it appears that Ferguson ignores the discount rate, closer examination reveals

that the use of the standard growth rate in the denominator of his equation, implies that

the investors will apply uniform discount rates to all equity earnings and that difference

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in price/ earnings ratio arise only from the differences in assumed growth rates and

duration.

A further assumption is made implicitly that the quoted growth rate stays on the same

level until period t and then drop off suddenly to a rate equivalent to the standard rate.

An analysis based on the foregoing assumption differs ofcourse very strongly from

Bausans Variable growth rate. That assumes evenly declining growth rates and

increasing discount rates for income with longer futurity.

In the last paragraph Ferguson states

We have not considered the fact that many stocks pay dividend which are an important

source of profit in addition to the price appreciation. This is especially true in situations

where the growth rate is of the same order of magnitude as the dividend yield. In these

instances the neglect of dividends may well result in incorrect calculation. An

approximate adjustment for the dividend income, useful in many instances would be to

add the yield to the per share earnings growth rate and use the resultant figure in place of

the growth rate

This implicitly assumes that the current market price of stock completely disregards

dividend payments. Moreover, this procedure would represent double counting and

overstate justifiable price/earning ratios for the growth stocks, since dividend payout is

already implicitly in the standard price/earnings ratio used in his equation.

Nicholas Molodovsky believes that any standardized selections of future periods, such

as 10 years for instanse, cold serve illustrative purpose only. He stressed that in actual

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practice, projections of future earnings trends of different stock would have to be made

for whatever varying period might be successfully indicated. The nature of the industry

to which a company belongs- as well as the corporations particular characteristics-

should in reality determine both the length of the period for which the earnings are

projected into the future and also the delicate process of the splicing with an overall

historical date. Depending on each individual case, such a transition may well take the

form of mathematical curves with very different graduations of diminishing rates of

growth. Such gradual transition can be easily performed by a computer, which could also

carry out the valuation formulas requirements of an infinite time horizon. According to

him this later condition can be easily met by combining the compound interest formula

used for complying a bonds yield maturity with the expression of geometric progression

for an infinite number of terms, which constitute a mathematical description of an

equities habitual market.

According to him the appropriate rate will take into consideration the risks involved,

which are influenced by the growth of earnings or dividend expected in the future, and

the expected future price. In short, risk is a function of the variability of return. A higher

discount rate will be employed whether the risk is greater and lower one when the risk is

lower.

One commonly used approach is based on the multiple growth models and a view that

companies typically evolve through 3 stages during their lifetime.

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These stages are

1. Growth stage

The stage is characterized by rapidly expanding sales, higher profit margins and

abnormally high growth in the EPS. Because the expected profitability of new

investment opportunities is high, the payout ratio is generally low. The unusually high

earnings enjoyed in this stage attract competitors leading to a gradual decline in the

growth stage.

2. Transition stage

In the later years of the companys life increased profit saturations begin to reduce its

growth rate, and its profit margins come under pressure. Since there are fewer

investment opportunities the company begins to payout a large percentage of earnings.

3. Maturity stage

Generally, the company reaches a position where its new investment opportunities offer,

on average, slightly attractive returns on equity. At that time, its earning growth rate,

payout ratio, and average return on equity stabilize for the remaining life of the

company.

In implementing the multiple growth model the analyst must estimate a number of

variables for each security being evaluated. One method involves estimating values for

the following variables

1. Expected earnings and dividend for the next five years

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2. The growth rate of earnings and the payout ratio for the transition stages which is

assured to be in year six.

3. The duration of the transition stage--- that is the number of years until the company

reaches the maturity stage.

4. Growth patters for the EPS and the payout ratio for the growth stage

5. The combination of the earnings growth rate and payout ratio that provides the

desired average return on equity for the next investment during the maturity stage.

Jeeremy C criticizes methods of comparative valuation because they are either base don

price / earnings ratio or on price dividend ratios. He argues that, no one approach will

give satisfactory results in a wide variety of common stocks because there are two

investment reasons for owning common stock dividend income and hope of capital

appreciation if the company grows. Thus there really is no sharp dividing line between an

income stock and a growth stock.

In this technique two different multipliers are computed, one to be applied to the dividend

from one set of factors, and another multiplier from another set of factors to be applied to

the earnings retained in the business. The two resultant values are added together in order

to obtain the value of equity.

The dividend multiplier is based on the assumption that the value of a dividend is a

function of the yield on a higher grade, or money rate, etc and the following factors

1. Debt + Preference as % of capital

2. Debt + Preference as % of working capital

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3. Pay out in % form

4. Total plow back as % of equity.

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Price cash flow ratio.

Instead of price earning ratio many analysts prefer to look at price cash flow ratio. A

price cash flow ratio is measured as the companys current stock price divided by its

current annual cash flow per share.

There are varieties of definitions of cash flow. In this context, the most famous measure

is simply calculated as net income plus depreciation, so this is the one we use here. Cash

flow is usually reported in firms financial statement and labeled as cash flow from

operations.

The difference between cash and earnings is often confusing largely because the way

standard accounting practice defines net income. Essentially net income is measured as

incomes minus expenses. Obviously this is logical. However not all are actual cash

expenses. The most important exception is depreciation.

When a firm acquires a long-lived asset such as new factor facility, standard accounting

practice does not deduct the cost of the factory at all once, even though it is actually paid

for all at once. Instead the cost is deducted over time. These deductions do not represent

actual cash payments, however. The actual cash payments occurred when the factory

was purchased. Most analysts agree that in examining a companys financial

performance, cash flow can be more informative than the net income.

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Price sales ratio

An alternative view of companys performance is provided by the price sales ratio. A

price sales ratio is calculated as the current price of the stocks divided by the current

annual sales revenue per share. A high P/S ratio would suggest high sales growth, while

a low would suggest sluggish sales growth.

Price book ratio

A very basic price ratio for a company is the price book ratio, sometimes called the

market book ratio. A price book ratio is measures as the market value of a companys

equity issued divided by the book value of the equity.

They are appealing because book value represents, in principle, historical cost. The stock

price is an indicator of current book value, so a price book ratio simply measures what

the equity is worth today relative to what it costs. A ratio bigger than 1 indicated that the

firm has been successful in creating value for its stockholders. A ratio less than 1

indicated that the company has infact lost the value for its shareholders.

This interpretation of this ratio seems simple enough, but the truth is that of varied and

changing accounting standards, book values are difficult to interpret. For this and other

reasons, price book ratios may not have much information as they once did.

All the above ratios discussed are commonly used to calculate the estimates of expected

future prices. Multiplying a historical average price ratio by an expected future value for

the price ratio denominator variable does this.

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Valuation equations for finding expected

returns

To get optimal risk return on an investment, the investors are to find the expected

returns. This is done by substituting the current price for equity value and solving return

by trial and error basis with the present value or the discount value being found when the

present value of inflows matches the current price.

To solve the equation and to get the estimates of earnings growth rate, and the price

earning ratio expected in year 3 several approaches are given below;

Random valuation model

The random valuation model begins with the premise that the next 3 years growth of

earnings dividend and price will be similar to those of 10 years. This is similar to the

valuation for estimating the rate of return. In random, the ten-year growth rate of

earnings and dividends is used, along with the ten year P/E ratio. But instead of

assuming that the 10-year rate will continue in future it is assumed that the rate is

unknown but it is likely to be within the value established by the 10-year mean value and

the standard deviation around the mean value of its estimate. This applies to each of the

variable that is to be substituted into the valuation equation to be solved for r i.e. return.

Three variables must be estimated in the valuation equation to establish r. They are

expected dividend growth rate, earnings growth rate and the expected P/E ratio in the

third year. The value for each variable assumes to be around the historic mean plus one

standard deviation of the estimate.

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Intrinsic value

What Is Intrinsic Value?

The concept of intrinsic value has been characterized above in terms of the value that

something has in itself, or for its own sake, or as such, or in its own right. The

custom has been not to distinguish between the meanings of these terms, but we will see

that there is reason to think that there may in fact be more than one concept at issue here.

For the moment, though, let us ignore this complication and focus on what it means to

say that something is valuable for its own sake as opposed to being valuable for the sake

of something else to which it is related in some way. Perhaps it is easiest to grasp this

distinction by way of illustration.

Suppose that someone were to ask you whether it is good to help others in time of need.

Unless you suspected some sort of trick, you would answer, Yes, of course. If this

person were to go on to ask you why acting in this way is good, you might say that it is

good to help others in time of need simply because it is good that their needs be satisfied.

If you were then asked why it is good that people's needs be satisfied, you might be

puzzled. You might be inclined to say, It just is. Or you might accept the legitimacy of

the question and say that it is good that people's needs be satisfied because this brings

them pleasure. But then, of course, your interlocutor could ask once again, What's good

about that? Perhaps at this point you would answer, It just is good that people be

pleased, and thus put an end to this line of questioning. Or perhaps you would again

seek to explain the fact that it is good that people be pleased in terms of something else

that you take to be good. At some point, though, you would have to put an end to the

questions, not because you would have grown tired of them (though that is a distinct

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possibility), but because you would be forced to recognize that, if one thing derives its

goodness from some other thing, which derives its goodness from yet a third thing, and

so on, there must come a point at which you reach something whose goodness is not

derivative in this way, something that just is good in its own right, something whose

goodness is the source of, and thus explains, the goodness to be found in all the other

things that precede it on the list. It is at this point that you will have arrived at intrinsic

goodness. That which is intrinsically good is nonderivatively good; it is good for its own

sake. That which is not intrinsically good but extrinsically good is derivatively good; it is

good, not (insofar as its extrinsic value is concerned) for its own sake, but for the sake of

something else that is good and to which it is related in some way. Intrinsic value thus

has a certain priority over extrinsic value. The latter is derivative from or reflective of the

former and is to be explained in terms of the former. It is for this reason that philosophers

have tended to focus on intrinsic value in particular.

The account just given of the distinction between intrinsic and extrinsic value is rough,

but it should do as a start. Certain complications must be immediately acknowledged,

though. First, there is the possibility, mentioned above, that the terms traditionally used to

refer to intrinsic value in fact refer to more than one concept; again, this will be addressed

later (in this section and the next). Another complication is that it may not in fact be

accurate to say that whatever is intrinsically good is nonderivatively good; some intrinsic

value may be derivative. This issue will be taken up (in Section 5) when the computation

of intrinsic value is discussed; it may be safely ignored for now. Still another

complication is this. It is almost universally acknowledged among philosophers that all

value is supervenient on certain nonevaluative features of the thing that has value.

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Roughly, what this means is that, if something has value, it will have this value in virtue

of certain nonevaluative features that it has; its value can be attributed to these features.

For example, the value of helping others in time of need might be attributed to the fact

that such behavior has the feature of being causally related to certain pleasant experiences

induced in those who receive the help. Suppose we accept this and accept also that the

experiences in question are intrinsically good. In saying this, we are (barring the

complication to be discussed in Section 5) taking the value of the experiences to be

nonderivative. Nonetheless, we may well take this value, like all value, to be

supervenient on something. In this case, we would probably simply attribute the value of

the experiences to their having the feature of being pleasant. This brings out the subtle

but important point that the question whether some value is derivative is distinct from the

question whether it is supervenient. Even nonderivative value (value that something has

in its own right; value that is, in some way, not attributable to the value of anything else)

is usually understood to be supervenient on certain nonevaluative features of the thing

that has value (and thus to be attributable, in a different way, to these features).

To repeat: whatever is intrinsically good is (barring the complication to be discussed in

Section 5) nonderivatively good. It would be a mistake, however, to affirm the converse

of this and say that whatever is nonderivatively good is intrinsically good. As intrinsic

value is traditionally understood, it refers to a particular way of being nonderivatively

good; there are other ways in which something might be nonderivatively good. For

example, suppose that your interlocutor were to ask you whether it is good to eat and

drink in moderation and to exercise regularly. Again, you would say, Yes, of course. If

asked why, you would say that this is because such behavior promotes health. If asked

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what is good about being healthy, you might cite something else whose goodness would

explain the value of health, or you might simply say, Being healthy just is a good way to

be. If the latter were your response, you would be indicating that you took health to be

nonderivatively good in some way. In what way, though? Well, perhaps you would be

thinking of health as intrinsically good. But perhaps not. Suppose that what you meant

was that being healthy just is good for the person who is healthy (in the sense that it is

in each person's interest to be healthy), so that John's being healthy is good for John,

Jane's being healthy is good for Jane, and so on. You would thereby be attributing a type

of nonderivative interest-value to John's being healthy, and yet it would be perfectly

consistent for you to deny that John's being healthy is intrinsically good. If John were a

villain, you might well deny this. Indeed, you might want to insist that, in light of his

villainy, his being healthy is intrinsically bad, even though you recognize that his being

healthy is good for him. If you did say this, you would be indicating that you subscribe to

the common view that intrinsic value is nonderivative value of some peculiarly moral

sort.

Let us now see whether this still rough account of intrinsic value can be made more

precise. One of the first writers to concern himself with the question of what exactly is at

issue when we ascribe intrinsic value to something was G. E. Moore [1873-1958]. In his

book Principia Ethica, Moore asks whether the concept of intrinsic value (or, more

particularly, the concept of intrinsic goodness, upon which he tended to focus) is

analyzable. In raising this question, he has a particular type of analysis in mind, one

which consists in breaking down a concept into simpler component concepts. (One

example of an analysis of this sort is the analysis of the concept of being a vixen in terms

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of the concepts of being a fox and being female.) His own answer to the question is that

the concept of intrinsic goodness is notamenable to such analysis. In place of analysis,

Moore proposes a certain kind of thought-experiment in order both to come to understand

the concept better and to reach a decision about what is intrinsically good. He advises us

to consider what things are such that, if they existed by themselves in absolute

isolation, we would judge their existence to be good; in this way, we will be better able

to see what really accounts for the value that there is in our world. For example, if such a

thought-experiment led you to conclude that all and only pleasure would be good in

isolation, and all and only pain bad, you would be a hedonist. Moore himself deems it

incredible that anyone, thinking clearly, would reach this conclusion. He says that it

involves our saying that a world in which only pleasure existed a world without any

knowledge, love, enjoyment of beauty, or moral qualities is better than a world that

contained all these things but in which there existed slightly less pleasure. Such a view he

finds absurd.

Regardless of the merits of this isolation test, it remains unclear exactly why Moore finds

the concept of intrinsic goodness to be unanalyzable. At one point he attacks the view

that it can be analyzed wholly in terms of natural concepts the view, that is, that we

can break down the concept of being intrinsically good into the simpler concepts of being

A, being B, being C, where these component concepts are all purely descriptive rather

than evaluative. (One candidate that Moore discusses is this: for something to be

intrinsically good is for it to be something that we desire to desire.) He argues that any

such analysis is to be rejected, since it will always be intelligible to ask whether (and,

presumably, to deny that) it is good that something be A, B, C,, which would not be the

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case if the analysis were accurate. Even if this argument is successful (a complicated

matter about which there is considerable disagreement), it of course does not establish the

more general claim that the concept of intrinsic goodness is not analyzable at all, since it

leaves open the possibility that this concept is analyzable in terms of other concepts,

some or all of which are not natural but evaluative. Moore apparently thinks that his

objection works just as well where one or more of the component concepts A, B, C,, is

evaluative; but, again, many dispute the cogency of his argument. Indeed, several

philosophers have proposed analyses of just this sort. For example, Roderick Chisholm

[1916-1999] has argued that Moore's own isolation test in fact provides the basis for an

analysis of the concept of intrinsic value. He formulates a view according to which (to

put matters roughly) to say that a state of affairs is intrinsically good or bad is to say that

it is possible that its goodness or badness constitutes all the goodness or badness that

there is in the world.

Eva Bodanszky and Earl Conee have attacked Chisholm's proposal, showing that it is, in

its details, unacceptable. However, the general idea that an intrinsically valuable state is

one that could somehow account for all the value in the world is suggestive and

promising; if it could be adequately formulated, it would reveal an important feature of

intrinsic value that would help us better understand the concept. We will return to this

point in Section 5. Rather than pursue such a line of thought, Chisholm himself has

responded in a different way to Bodanszky and Conee. He has shifted from what may be

called an ontologicalversion of Moore's isolation test the attempt to understand the

intrinsic value of a state in terms of the value that there would be if it were the only

valuable state in existence to an intentional version of that test the attempt to

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understand the intrinsic value of a state in terms of the kind of attitude it would be

appropriate to have if one were to contemplate the valuable state as such, without

reference to circumstances or consequences. This new analysis in fact reflects a general

idea that has a rich history. Franz Brentano [1838-1917], C. D. Broad [1887-1971], W. D.

Ross [1877-1971], and A. C. Ewing [1899-1973], among others, have claimed, in a more

or less qualified way, that the concept of intrinsic goodness is analyzable in terms of the

worthiness of some attitude. Such an analysis is supported by the mundane observation

that, instead of good, we often use the term valuable, which itself just means: worthy

of being valued. It would thus seem very natural to suppose that for something to be

intrinsically good is simply for it to be worthy of being valued for its own sake.

(Worthy here is usually understood to signify a particular kind of moral worthiness, in

keeping with the idea that intrinsic value is a particular kind of moral value. The

underlying point is that those who value for its own sake that which is intrinsically good

thereby evince a kind ofmoralsensitivity.) Though undoubtedly attractive, this analysis

can be and has been challenged. Brand Blanshard [1892-1987], for example, has claimed

that, even if it is necessarily true that whatever is intrinsically good is worthy of being

valued for its own sake, and vice versa, the proposed analysis of the concept of intrinsic

goodness in these terms must be rejected because, if we askwhy something is worthy of

being valued for its own sake, the answer is that this is the case precisely because the

thing in question is intrinsically good; this answer indicates that the concept of intrinsic

goodness is more fundamental than that of the worthiness of being valued, which is

inconsistent with analyzing the former in terms of the latter. Ewing and others have

resisted this type of argument. Note that, even if the argument succeeds, it may

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nonetheless be necessarily true that whatever is intrinsically good is worthy of being

valued for its own sake, and vice versa. If this were the case, it would reveal another

important feature of intrinsic value, recognition of which would again help us to improve

our understanding of this concept.

One final cautionary note. It is apparent that some philosophers use the term intrinsic

value and similar terms to express some concept other than the one just discussed. In

particular, Immanuel Kant [1724-1804] is famous for saying that the only thing that is

good without qualification is a good will, which is good not because of what it effects

or accomplishes but in itself.This may seem to suggest that Kant ascribes (positive)

intrinsic value only to a good will, declaring the value that anything else may possess

merely extrinsic, in the senses of intrinsic value and extrinsic value discussed above.

This suggestion is, if anything, reinforced when Kant immediately adds that a good will

is to be esteemed beyond comparison as far higher than anything it could ever bring

about, that it shine[s] like a jewel for its own sake, and that its usefulnesscan

neither add to, nor subtract from, [its] value. For here Kant may seem not only to be

invoking the distinction between intrinsic and extrinsic value but also to be in agreement

with Brentano et al. regarding the characterization of the former in terms of the

worthiness of some attitude, namely, esteem. (The term respect is often used in place of

esteem in such contexts.) Nonetheless, it becomes clear on further inspection that Kant

is in fact discussing a concept quite different from that with which this article is

concerned. A little later on he says that all rational beings, even those that lack a good

will, have absolute value; such beings are ends in themselves that have a dignity or

intrinsic value that is above all price. Such talk indicates that Kant believes that the

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sort of value that rational beings possess is infinitely great. But then, if this were

understood as a thesis about intrinsic value as we have been understanding this concept,

the implication would seem to be that, since it contains persons, our world is as good as it

could be. Yet this is something that Kant explicitly rejects elsewhere. It seems best to

understand Kant, and other philosophers who have since written in the same vein, as

being concerned not with the question of what intrinsic value rational beings have in

the sense of intrinsic value discussed above but with the quite different question of

how we ought to behave toward such creatures.

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Market anomaly models

If the stock markets were totally efficient, then there would be no systematic gain from

investing in stocks with certain easily identifiable characteristics such as low P/E, small

capitalization and low analyst coverage. However, such market anomalies do infact

exist. Donald kim discusses five sources of anamolous return in the stock market: high

dividend stocks, small capitalization stocks, low P/E stocks, abnormally high returns for

the month of January, and abnormally high returns for stocks rated 1 in the value line

timeless market.

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Capital asset pricing model:

Those who use the CAPM model for active equity management style employ its

prediction that in equilibrium, the expected stock return is an exact linear function of the

risk free rate, the beta for the stock, and he expected return on the market portfolio. This

linear equation is called the security market line. In theory, the stock whose expected

return from the valuation model equates the expected return from the CAPM is to be in

the equilibrium. If the expected return from the DDM were greater than the expected

return from the CAPM, then the market would adjust the price of the stock upward and

hence lower its expected return. If the expected return from the DDM were less than the

expected return from the CAPM, then the market would adjust the price upward and

hence lower its expected return. If the expected return of CAPM were less than the

expected return from the DDM then the market would adjust the price of the stock

downward and hence raise its expected return.

The CAPM has said a lot lesser so far as the prices are concerned. The discussion had

revolved around risk and expected returns. Concentrating on risk and return was simply a

convenient approach to the problem. Nonetheless, it is the security price, which is

transacted in the markets and which determines speculative opportunities exist.

The equilibrium price should not provide any opportunities for speculative profits. It

should be set at a level that expected returns from buying the security are identical to

those available on an efficient portfolio of equivalent non-diversifiable risk. The

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equilibrium pricing formula strictly applies to the single period world. There is no

warranty on its validity when it is used in other situations. In practice, however, the

principal features of the model are used widely. Security analysts forecast expected future

dividends and prices on a stock and discount them to the present using a discount rate

generated from SML.

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Strategies

The approaches explained are not mutually exclusive. Rather many of these models can

be used in combination with each other in sound judgment. The quantitative strategy in

valuation models may be defined as the engineered investment strategies. In developing

these strategies, consideration must be given at least to three characteristics.

First, strategy should be based on a sound theory. Thus, there should be not only

the reason why the strategy worked in the past , but more importantly, a reason

why should it be expected in the future.

Second, the strategy should be put in quantified terms.

Finally a determination should be made of how the strategy would have

performed in the past. This last characteristic is critical and is the reason why

investment strategies are back tested.

An equity manager encounters many potential problems in the design, testing, and

implementation of engineered investment strategies. These include

1. Insufficient rationale: There is insufficient rationale for why a strategy

worked in the past and why it is estimated that it will work in the future.

2. Blind assumptions: Some strategies are based on the blind assumption that

certain factors are always good or bad.

3. Data mining: Data mining occurs when so many strategies are tested that,

by the laws of chance, on works. This is related to the problem of insufficient

rationale and investment analyst uncovers statical relationships that are not expected

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to any investment theory or substantive model and may well be just a result of the

type or data or statically model used or per se chance.

4. Quantity of data: In searching for investment strategies, managers use

computerized historical data. These databases often suffer from problems of

inaccuracy, omissions, and survivor bias. Survivor bias occurs when the companies

that disappeared are eliminated from the database. As a result any testing of potential

strategy that includes only surviving companies would be biased in favor of

survivors.

5. Look- ahead bias: This bias involves testing an investment strategy using

data that would not have been available at the time the strategy was formulated. For

example the manager is testing a strategy involving price earnings ratio and performs

the following test. If the P/E ratio is greater than the specified value on December 31 st

then sell the stock on January 1st. If it is less than the specified value then buy the

stock. The look ahead bias is that the P/E ratio is based on actual earnings for the year

ending December 31st cannot be calculated on 31st December because actual earnings

for the year ending 31st December are reported in the first quarter next year. Thus in

conducting this back test the manager would be using data on 31st December that

were not available on that date.

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Conclusion:

Comparative selection decisions for most industrial equity shares can usually be

intelligently achieved through the appropriate use of one or more of the valuation

techniques. The data on individual equity derived from these techniques should ordinarily

be compared with the benchmark for a representative stock market average or index

given an indication of the comparative values available in the market. In all cases,

however a subjective interpretation of the various quality features is inherently a part of

the decision process.

However, it might be noted that even the most sophisticated appraisal techniques cannot

assure superior long-term investment results. Because results entirely depend upon the

realization of future earnings and dividend. Such possibilities are one reason for portfolio

diversification f reasonable proportions. But at the same time it would seem only

reasonable that selection decision derived from a penetrating analytical process of the

quality of the company and its earnings an dividend potential in relation to the price of

the stock should substantially increase the probabilities of obtaining satisfactory long

term investment results.

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Bibliography

1) Security analysis and portfolio management---- V K Bhalla

2) Security analysis and portfolio management---- Donald fischer

3) Various Internet sites

4) Modules of certified program in capital markets. (CPCM)

Documents

Equity valuation & Analysis-Bhargav Buddhadev-06