equity valution and analysis

8/11/2019 equity valution and analysis

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historical and current information is not fully and correctly reflected in the

current price of the stock. !ence 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. "y 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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CHAPTER 2

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. %fter identifying attractive and unattractive sectors and

industries, the top down manager finally selects the portfolio of individual

stocks.

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The process is represented in the figure given below&

Economic forecast

%sset allocation

'ector analysis

% manager who uses bottom up equity approach de(emphasies the

significance of economic and market styles and focuses instead on the

analysis of individual securities. )sing 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 capitaliation, low analyst coverage etc$

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*inancial markets

'tock markets +ther asset markets

Equity portfolio


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CHAPTER 3

Sub cateories o! active equity manaement

'ome of the maor sub categories of the two maor style of active equity

management are listed below&

"ro#t$ manaers: -rowth managers can be classified as either top(

down or bottom up. The growth managers are either divided into

large capitaliation or small capitaliation. The growth managers buy

securities that are typically selling at relatively high /0E ratios, due to

high earnings growth rate, with the expectation of continued high

earnings growth. The portfolios are characteried by high /0E ratios,

high returns, and relatively low dividend yields.

%ar&et 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 equities. 1ather he0she

moves in and out of the market depending on the economic, technical

and analytical skills he0she dictates.

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Heders:The hedger seems to buy equities but also to place well(

defined limits on the investor2s investment limits. +ne 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.

'alue manaers:These are sometimes referred to as contrarians. This

is because they sometimes see value where many other market

participants don2t. 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. 3alue managers

use dividend discount.

"rou( rotation manaers: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. !e can then select those sectors and

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economies that are going benefit. *or example if the economy were

perceived to be on the verge of moving from recession to recovery, the

group rotator would begin to purchase stocks in the appropriate

sectors and specific industries that are sensitive to the pick up in the

economy.

Tec$nicians:They discern market cycles and pick up securities solely

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

proected price movements. "y reading a chart and artfully discerning

patterns, the technician hopes to be able to predict the future path of

the price action models /0E, earning surplus etc. In terms of

characteristics, value managers have relatively low betas, low price

book and /0E ratios and high dividend yields.

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CHAPTER )

Equity valuation models

The purpose of these models is to identify whether the stock is overpriced

or under priced. )nder priced stocks need to be purchased and over

priced stock need to be shorted4

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 rate then we can discount the same

and get the present value.

5et us consider an example. 'uppose we have an opportunity to receive 677

a year from now. 8ow if the interest rate is 69: then the present value shall

be

P'E * +uture value

,1-I./n

100

,1-12./1

* 2

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.

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5et us assume there is an investor whose cost of capital is &and decides to

invest in a company. %s a first step he calculates the adusted earnings per

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

growth and on the basis of these findings and of a company2s outlook

derives an estimate of the future earnings of the company. *or 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 investor4

-iven the data the value can be calculated as below&

' * E - E -44 E

,1-&. ,1-&./2 ,1-&./t

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

investor2s cost of capital measures the intrinsic value of the share. 8ow we

compare this valuation with the current stock price #/$. 8ow if 3(/ifferent investors can be expected to evaluate the investments differently.

'ome will decide to buy the equity while others will decide to sell the

equity if they already sell now. This differential behaviour reflects two

principal factors&

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a$ >ifferent individuals have different cost of capital so that calculation

using one discount rate may result in negative 8/3

while the use of other discount rate may be give a positive 8/3.

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

estimates of the firm2s profitability may result in different investment

decisions.

5ASIC %67E8: +ne of the most used equity valuation model is the

dividend discount model. In its simplest form, the >>? defines the intrinsic

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

variations of the >>? because of different assumptions about the growth

rate of dividend and its relationship to the discount rate used to calculate

present values.

9ER6 "R6TH %67E8S:The most basic of all the >>' is the ero

growth model. This model assumes that the dividend will be constant over

time, so that growth is ero, and that the investor2s required rate of return is

constant.

C6;STA;T "R6TH %67E8S: In this model cash dividends are

expected to grow at the constant rate. In order to find the discounted present

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value of the stream of constantly rising dividends, the investors can use the

equation of constant growth of dividends.

Intrinsic 'alue * 71


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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&

'alue * 7o ,1-?./t

,1-&./t

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&

Intrinsic 'alue * 7o,1-?.t - 7n-1 @ 1

,1-&.t ,&=y. ,1-&./n

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

consider the case of this hypothetical company DF.

The company paid its first cash dividend of 1s.9.A today and dividends are

expected to grow at the rate of G7: for the next G years. Thereafter cash

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dividends are expected to grow at the rate of 67:. *urther the shareholders

are expecting 6A: rate of return.

Solution:

*irst we shall calculate the present value of dividends for the first G years&

ear >ividend

>o#6Hgx$t

Capitaliation

rate

/resent value

#6$ #9$ #G$ #@$;#9$J#G$

7 9.A

6 G.9A .KL7 9.K9LA

9 @.99A .LAM G.6B@6G A.@BG .MAK G.M6@7

')? ; 9.6356

'tep 9

3alue at the end of the Grdyear for the remaining life of the company will be&

73 ,1-?. * >)3,1-10.*B0)23

Therefore value at the end of the third year

'3 * B0)23

,1>=10.

* 120)B

Therefore the present value is 697.@KMJ .MAK ;79.2797

Thus the value of the share is B.MGAM HLB.9LBL ; 88.9153

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CHAPTER >

'aluation models !or cyclical stoc&s:

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"auman 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. !e 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 find its growth rate

declining to the average shown in an industry. !ow long this

transition period lasts depends on the company, industry, product,

competition etcN % guide to follow is to determine the probable

position of the company in its life cycle.

*or example, if a company has been experiencing an abnormally high

growth rate, "auman suggests that, unless there is a sufficient evidence to

the contrary, the best earnings and dividend proection is probably based on

a decreasing rate of growth, until it eventually approximates the secular

growth rate for the maority of the companies in the company. *or 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.

%ccording to him in order to make a good estimate of future dividends, the

investor must ascertain

#a$ the current growth rate of dividend

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#b$ how long will it take until the growth rate has declined to the average

typical for the maority of corporations.

+nce 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

rate4 "auman offers guidelines from M to 67 percent depending on the risk

involved.

The discount rate applied to the first year2s 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.

%lthough 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 maority stock exchanges. "auman relies a lot on historical

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

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

on guard constantly to recognie signs of changes.

+bviously the cyclical model is difficult to formulate even on simple

configuration, but it does point out the variables that must be considered.

5et us assume that a stock has @ years business cycle from trough to peak to

trough, that the stock pays a regular dividend, and that the investor is willing

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to trade in and out of the stock but since the risks are great he must earn a

97: rate of return rather than a 67:

8ow if >6 is 6 and >9 is 6.K and /9 is K7, the present value of the stream of

income at 97: is

Intrinsic 'alue * 1 - 1

,1-12. ,1-12./2

* >0

Therefore, if the stock is available at lower than AL.7K then it would provide

the speculative investor with a yield of over 97:. "ut 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. ?ay be his funds were placed in the savings bank.

' * 71 -72-C"2 -I3 -7) -7> - 7B-PB ,1-&. ,1-&./2 ,1-&./3 ,1-&./) ,1-&./> ,1-&./B

Where C-9 is the capital gain in year 9, IG and I@ are interest income and

>6, >9N 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 K: savings account then to repurchase at a low, and a final sale at a peak

in year M. It is obvious that this is difficult to do in practice and that the cycle

might be substantially shorter than six years.

CHAPTER B

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%odel based on (rice ratio analysis

i. Price equity ratio

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

company2s price equity ratio abbreviated as /0E ratio. It is calculated as the

ratio of the firm2s current stock price divided by the earnings per share

#E/'$.

The inverse of the p0e 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 /0E ratios.

'ince 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.

?ost analysts prefer the first method of multiplying the latest quarterly

earnings per share value time four. !owever the difference is usually small,

but it can sometimes be source of confusion.

%nalysts often refer to high /0E stocks as growth stocks. To see why notice

that a /0E ratio is measured as a current stock price over current earnings

per share. 8ow consider two companies with the same current earnings per

share, where one company is a high growth company and the other is a low

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growth company. Which company should have a higher stock price, the

high growth company or the low growth company4

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 /0E ratio. In general companies with higher expected earnings will

have higher /0E ratio, which is why /0E stocks are referred to as the growth

stocks.

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

is that low /0E 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. !owever it should be rated that

the term growth stock and value stock are most ustly commonly used

labels. +f course only time will tell whether a low /0E stock is of good

value.

The /0E ratio used in the valuation equation is influenced by

i$ /0E 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 /0E ratios. The future level of the /0E ratio can

be viewed as the function of the current /0E ratios or the average /0E

ratio over the same period of time.

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ii$ The /0E ratio is a function of future expected earnings the higher the

growth rate of earnings the higher will be the /0E ratio. %n 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$ % normal /0E for the market is difficult to determine. % normal /0E

ratio is established for each company but it can be compared to the

market /0E to give some idea of risk. The higher the /0E 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 /0E ratios

v$ !igher interest rates tend to reduce the /0E ratios

vi$ /0E ratios vary by the industry

vii$ %n investor should examine the trend of the /0E ratio over time for

each company.

viii$ The level of /0E ratio is not an absolute one but a relative one.

ix$ 'peculative companies and cyclical companies tend to have a lower

/0E

x$ -rowth companies tend to have a higher /0E

xi$ Companies with larger portion of debt tend to have a lower /0E

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xii$ % company that tends to pay a higher dividend tend to have a higher

/0E

xiii$ /0E ratios can change radically and suddenly because of change the

expected growth rate of earnings. Therefore the greater the expected

stability of the growth rates the higher the /0E ratio.

!ow can the /0E ratio be used as guide in making an investment decision4

*or this the analyst is to apply various rules of thumb on company2s

earnings selecting an appropriate /0E 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. *or this the analyst mat ascertains

the median or the mean /0E for the equity as well as its range over the time.

?ore weight can be given to the recent past. This provides boundaries

within which the /0E must fall and indicates whether the equity is tending to

sell at the upper limits of expectation or the lower limits. Industry /0E

provide the guidelines, however the different companies in the same

industry frequently carry different /0Es. 1obert *erguson presents a method

of determining ustifiable price earnings ratio for growth stocks as

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compared to the standard. !is obectives are to answer the following

questionsO

%$ !ow many years of the present high growth rate are assumed by today2s

market price before the growth rate of the company drops to the standard

rate4

"$ What price earning ratio is ustified given a certain growth rate which is

higher than the standard rate for a certain number of years 4

*erguson takes the market price as a base and then determines what

estimates of the basic factors the market makes. !e then leaves the investors

to decide whether these estimates are too low or too high in his udgement.

*erguson 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.

/a ; #6H1a$n

/6a #6H1b$n

Where

/a ; some standard price earning ratio

/6a ; growth stock price earning ratio

1a ; standard growth rate assumed

1b ; rate of growth assumed for growth stock

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%lthough it appears that *erguson 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 in price0 earnings

ratio arise only from the differences in assumed growth rates and duration.

% 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. %n analysis based on the foregoing assumption differs

ofcourse very strongly from "ausans 3ariable growth rate. That assumes

evenly declining growth rates and increasing discount rates for income with

longer futurity.

In the last paragraph *erguson states

PWe 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. %n approximate adustment 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 rateQ

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This implicitly assumes that the current market price of stock completely

disregards dividend payments. ?oreover, this procedure would represent

double counting and overstate ustifiable price0earning ratios for the growth

stocks, since dividend payout is already implicitly in the standard

price0earnings ratio used in his equation.

;ic$olas %olodovs&ybelieves that any standardied selections of future

periods, such as 67 years for instanse, cold serve illustrative purpose only.

!e stressed that in actual practice, proections 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

proected into the future and also the delicate process of the Rsplicing2 with

an overall historical date. >epending on each individual case, such a

transition may well take the form of mathematical curves with very different

graduations of diminishing rates of growth. 'uch gradual transition can be

easily performed by a computer, which could also carry out the valuation

formula2s requirements of an infinite time horion. %ccording to him this

later condition can be easily met by combining the compound interest

formula used for complying a bond2s yield maturity with the expression of

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geometric progression for an infinite number of terms, which constitute a

mathematical description of an equities habitual market.

%ccording 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. % higher discount rate will be employed

whether the risk is greater and lower one when the risk is lower.

+ne commonly used approach is based on the multiple growth models and a

view that companies typically evolve through G stages during their lifetime.

These stages areO

1 "ro#t$ stae

The stage is characteried by rapidly expanding sales, higher profit margins

and abnormally high growth in the E/'. "ecause the expected profitability

of new investment opportunities is high, the payout ratio is generally low.

The unusually high earnings enoyed in this stage attract competitors leading

to a gradual decline in the growth stage.

2 Transition stae

In the later years of the company2s life increased profit saturations begin to

reduce its growth rate, and its profit margins come under pressure. 'ince

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there are fewer investment opportunities the company begins to payout a

large percentage of earnings.

1 %aturity stae

-enerally, the company reaches a position where its new investment

opportunities offer, on average, slightly attractive returns on equity. %t that

time, its earning growth rate, payout ratio, and average return on equity

stabilie 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. +ne method involves

estimating values for the following variables

6. Expected earnings and dividend for the next five years

9. The growth rate of earnings and the payout ratio for the transition stages

which is assured to be in year six.

G. The duration of the transition stage((( that is the number of years until

the company reaches the maturity stage.

@. -rowth patters for the E/' and the payout ratio for the growth stage

A. 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.

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Seeremy C criticies methods of comparative valuation because they are

either base don price 0 earnings ratio or on price dividend ratios. !e argues

that, Pno one approach will give satisfactory results in a wide variety of

common stocksN because there are two investment reasons for owning

common stockN 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

6. >ebt H /reference as : of capital

9. >ebt H /reference as : of working capital

G. /ay out in : form

@. Total plow back as : of equity.

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Price cas$ !lo# ratio.

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

ratio. % price cash flow ratio is measured as the company2s 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 firm2s 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. +bviously this is logical.

!owever 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. ?ost

analysts agree that in examining a company2s financial performance, cash

flow can be more informative than the net income.

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Price sales ratio

%n alternative view of company2s performance is provided by the price

sales ratio. % price sales ratio is calculated as the current price of the stocks

divided by the current annual sales revenue per share. % high /0' ratio

would suggest high sales growth, while a low would suggest sluggish sales

growth.

Price boo& ratio

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

called the market book ratio. % price book ratio is measures as the market

value of a company2s 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. % ratio bigger than 6 indicated that the firm has been successful in

creating value for its stockholders. % ratio less than 6 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. *or this and other reasons, price book ratios may not have much

information as they once did.

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%ll the above ratios discussed are commonly used to calculate the estimates

of expected future prices. ?ultiplying a historical average price ratio by an

expected future value for the price ratio denominator variable does this.

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CHAPTER

'aluation equations !or !indin e?(ected 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 G several approaches are given

below&

Random valuation model

The random valuation model begins with the premise that the next G years

growth of earnings dividend and price will be similar to those of 67 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 /0E ratio. "ut instead of assuming that the 67(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 67(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

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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 /0E ratio in the third year. The value for each variable

assumes to be around the historic mean plus one standard deviation of the

estimate.

Intrinsic value

$at Is Intrinsic 'alueD

The concept of intrinsic value has been characteried above in terms of the

value that something has Pin itself,Q or Pfor its own sake,Q or Pas such,Q or

Pin its own right.Q 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. *or the moment,

though, let us ignore this complication and focus on what it means to say

that something is valuablefor its own sakeas opposed to being valuablefor

the sake of something elseto which it is related in some way. /erhaps it is

easiest to grasp this distinction by way of illustration.

'uppose that someone were to ask you whether it is good to help others in

time of need. )nless you suspected some sort of trick, you would answer,

Pes, of course.Q If this person were to go on to ask you why acting in this

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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 peoples needs be satisfied, you might be puled.

ou might be inclined to say, PIt ust is.Q +r you might accept the legitimacy

of the question and say that it is good that peoples needs be satisfied

because this brings them pleasure. "ut then, of course, your interlocutor

could ask once again, PWhats good about that4Q /erhaps at this point you

would answer, PIt ust is good that people be pleased,Q and thus put an end to

this line of questioning. +r 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. %t 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 possibility$, but because you would be forced to recognie 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 Pust isQ 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

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good& it is good for its ownsake. 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 ust 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. *irst, 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$. %nother 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 'ection A$

when the computation of intrinsic value is discussed& it may be safely

ignored for now. 'till another complication is this. It is almost universally

acknowledged among philosophers that all value is PsupervenientQ on

certain nonevaluative features of the thing that has value. 1oughly, what this

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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. *or 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.

'uppose 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 'ection A$ taking the value of the experiences to be

nonderivative. 8onetheless, 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 valueof 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 repeatO whatever is intrinsically good is #barring the complication to be

discussed in 'ection A$ nonderivatively good. It would be a mistake,

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however, to affirm the converse of this and say that whatever is

nonderivatively good is intrinsically good. %s Pintrinsic valueQ is

traditionally understood, it refers to a particular way of being no

derivatively good& there are other ways in which something might be

nonderivatively good. *or example, suppose that your interlocutor were to

ask you whether it is good to eat and drink in moderation and to exercise

regularly. %gain, you would say, Pes, of course.Q If asked why, you would

say that this is because such behavior promotes health. If asked what is good

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

explain the value of health, or you might simply say, P"eing healthy ust is a

good way to be.Q If the latter were your response, you would be indicating

that you took health to be nonderivatively good in some way. In what way,

though4 Well, perhaps you would be thinking of health as intrinsically good.

"ut perhaps not. 'uppose that what you meant was that being healthy ust is

Pgood forQ the person who is healthy #in the sense that it is in each persons

interest to be healthy$, so that Sohns being healthy is good for Sohn, Sanes

being healthy is good for Sane, and so on. ou would thereby be attributing a

type of nonderivative interest(value to Sohns being healthy, and yet it would

be perfectly consistent for you to deny that Sohns being healthy is

intrinsicallygood. If Sohn were a villain, you might well deny this. Indeed,

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you might want to insist that, in light of his villainy, his being healthy is

intrinsically bad, even though you recognie 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 moralsort.

5et us now see whether this still rough account of intrinsic value can be

made more precise. +ne of the first writers to concern himself with the

question of what exactly is at issue when we ascribe intrinsic value to

something was -. E. ?oore U6KLG(6BAKV. In his book Principia Ethica,

?oore asks whether the concept of intrinsic value #or, more particularly, the

concept of intrinsic goodness, upon which he tended to focus$ is analyable.

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

which consists in Pbreaking downQ a concept into simpler component

concepts. #+ne example of an analysis of this sort is the analysis of the

concept of being a vixen in terms of the concepts of being a fox and being

female.$ !is own answer to the question is that the concept of intrinsic

goodness is not amenable to such analysis. In place of analysis, ?oore

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. !e advises us to consider what things are such that, if

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they existed by themselves Pin absolute isolation,Q we would udge 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. *or 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. ?oore

himself deems it incredible that anyone, thinking clearly, would reach this

conclusion. !e says that it involves our saying that a world in which only

pleasure existed a world without any knowledge, love, enoyment of

beauty, or moral qualities is better than a world that contained all these

things but in which there existed slightly less pleasure. 'uch a view he finds

absurd.

1egardless of the merits of this isolation test, it remains unclear exactly why

?oore finds the concept of intrinsic goodness to be unanalyable. %t one

point he attacks the view that it can be analyed wholly in terms of PnaturalQ

concepts the view, that is, that we can break down the concept of being

intrinsically good into the simpler concepts of beingA, beingB, being CN,

where these component concepts are all purely descriptive rather than

evaluative. #+ne candidate that ?oore discusses is thisO for something to be

intrinsically good is for it to be something that we desire to desire.$ !e

argues that any such analysis is to be reected, since it will always be

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intelligible to ask whether #and, presumably, to deny that$ it is good that

something beA, B, C,N, which would not be the 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 analyable at

all, since it leaves open the possibility that this concept is analyable in

terms of other concepts, some or all of which are not PnaturalQ but

evaluative. ?oore apparently thinks that his obection works ust as well

where one or more of the component conceptsA,B, C,N, is evaluative& but,

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

philosophers have proposed analyses of ust this sort. *or example, 1oderick

Chisholm U6B6M(6BBBV has argued that ?oores own isolation test in fact

provides the basis for an analysis of the concept of intrinsic value. !e

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 "odansky and Earl Conee have attacked Chisholms proposal, showing

that it is, in its details, unacceptable. !owever, the general idea that an

intrinsically valuable state is one that could somehow account for all the

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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 'ection

A. 1ather than pursue such a line of thought, Chisholm himself has

responded in a different way to "odansky and Conee. !e has shifted from

what may be called an ontologicalversion of ?oores 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

intentionalversion of that test the attempt to understand the intrinsic

value of a state in terms of the kind of attitude it would be appropriate to

have if one were to contemplatethe valuable state as such, without reference

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

general idea that has a rich history. *ran "rentano U6KGK(6B6LV, C. >.

"road U6KKL(6BL6V, W. >. 1oss U6KLL(6BL6V, and %. C. Ewing U6KBB(6BLGV,

among others, have claimed, in a more or less qualified way, that the concept

of intrinsic goodness is analyable in terms of the worthiness of some

attitude. 'uch an analysis is supported by the mundane observation that,

instead of Pgood,Q we often use the term Pvaluable,Q which itself ust meansO

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

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valued for its own sake. #PWorthyQ 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 of moralsensitivity.$ Though undoubtedly attractive, this analysis can

be and has been challenged. "rand "lanshard U6KB9(6BKLV, 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 reected

because, if we ask whysomething 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 analying the former in terms of the latter.

Ewing and others have resisted this type of argument. 8ote that, even if the

argument succeeds, it may 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.

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+ne final cautionary note. It is apparent that some philosophers use the term

Pintrinsic valueQ and similar terms to express some concept other than the

one ust discussed. In particular, Immanuel Xant U6L9@(6K7@V is famous for

saying that the only thing that is Pgood without qualificationQ is a good will,

which is good not because of what it effects or accomplishes but Pin

itself.QThis may seem to suggest that Xant ascribes #positive$ intrinsic value

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

merely extrinsic, in the senses of Pintrinsic valueQ and Pextrinsic valueQ

discussed above. This suggestion is, if anything, reinforced when Xant

immediately adds that a good will Pis to be esteemed beyond comparison as

far higher than anything it could ever bring about,Q that it PshineUsV like a

ewel for its own sake,Q and that its PusefulnessNcan neither add to, nor

subtract from, UitsV value.Q *or here Xant may seem not only to be invoking

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

agreement with "rentano et al.regarding the characteriation of the former

in terms of the worthiness of some attitude, namely, esteem. #The term

PrespectQ is often used in place of PesteemQ in such contexts.$ 8onetheless,

it becomes clear on further inspection that Xant is in fact discussing a

concept quite different from that with which this article is concerned. % little

later on he says that all rational beings, even those that lack a good will,

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have Pabsolute valueQ& such beings are Pends in themselvesQ that have a

PdignityQ or Pintrinsic valueQ that is Pabove all price.Q 'uch talk indicates

that Xant believes that the sort of value that rational beings possess is

infinitely great. "ut 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.

et this is something that Xant explicitly reects elsewhere. It seems best to

understand Xant, 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 Pintrinsic valueQ discussed above

but with the quite different question of how we ought to behave toward such

creatures.

%ar&et 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 /0E, small capitaliation and low analyst coverage. !owever,

such market anomalies do infact exist. >onald Xim discusses five sources of

anomalous return in the stock marketO high dividend stocks, small

capitaliation stocks, low /0E stocks, abnormally high returns for the month

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of Sanuary, and abnormally high returns for stocks rated P6Q in the value line

timeless market.

Ca(ital Asset Pricin %odel

Those who use the C%/? 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 C%/? is to be in the

equilibrium. If the expected return from the >>? were greater than the

expected return from the C%/?, then the market would adust the price of

the stock upward and hence lower its expected return. If the expected return

from the >>? were less than the expected return from the C%/?, then the

market would adust the price upward and hence lower its expected return. If

the expected return of C%/? were less than the expected return from the

>>? then the market would adust the price of the stock downward and

hence raise its expected return.

The C%/? has said a lot lesser so far as the prices are concerned. The

discussion had revolved around risk and expected returns. Concentrating on

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risk and return was simply a convenient approach to the problem.

8onetheless, 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 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. 'ecurity analysts forecast expected future dividends and prices

on a stock and discount them to the present using a discount rate generated

from '?5.

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CHAPTER

Strateies

The approaches explained are not mutually exclusive. 1ather many of these

models can be used in combination with each other in sound udgment. 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.

*irst, 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.

'econd, the strategy should be put in quantified terms.

*inally 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.

%n equity manager encounters many potential problems in the design,

testing, and implementation of engineered investment strategies. These

include

6. Insufficient rationaleO There is insufficient rationale for why a

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

future.

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9. "lind assumptionsO 'ome strategies are based on the blind

assumption that certain factors are always good or bad.

G. >ata miningO >ata 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 to any investment theory or

substantive model and may well be ust a result of the type or data or

statically model used or per se chance.

@. Yuantity of dataO In searching for investment strategies,

manager2s use computeried historical data. These databases often suffer

from problems of inaccuracy, omissions, and survivor bias. 'urvivor bias

occurs when the companies that disappeared are eliminated from the

database. %s a result any testing of potential strategy that includes only

surviving companies would be biased in favor of survivors.

A. 5ook( ahead biasO This bias involves testing an investment

strategy using data that would not have been available at the time the

strategy was formulated. *or example the manager is testing a strategy

involving price earnings ratio and performs the following test. If the /0E

ratio is greater than the specified value on >ecember G6st then sell the

stock on Sanuary 6st. If it is less than the specified value then buy the

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stock. The look ahead bias is that the /0E ratio is based on actual earnings

for the year ending >ecember G6stcannot be calculated on G6st>ecember

because actual earnings for the year ending G6st>ecember are reported in

the first quarter next year. Thus in conducting this back test the manager

would be using data on G6st>ecember that were not available on that

date.

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CHAPTER

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

subective interpretation of the various quality features is inherently a part of

the decision process.

!owever, it might be noted that even the most sophisticated appraisal

techniques cannot assure superior long(term investment results. "ecause

results entirely depend upon the realiation of future earnings and dividend.

'uch possibilities are one reason for portfolio diversification f reasonable

proportions. "ut 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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5ibliora($y

1. Security analysis and (ort!olio manaement==== ' < 5$alla

2. Security analysis and (ort!olio manaement==== 7onald +isc$er

3. %odules o! certi!ied (roram in ca(ital mar&ets ,CPC%.

equity valution and analysis

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